2. Growth in the open economy Flashcards
What are the two main forms of economic integration i.e. transition from autarky to open economy?
Open trade and free flow of factors of production.
What are the two channels through which openness to the world market can affect economic growth of a country?
Openness affects growth through the channel of factor accumulation or through the channel of productivity.
In other words, are more open countries richer because they have more physical and human capital for each worker to work with, or are they richer because they use their factors of production more effectively?
First channel of the effect of openness on growth: factor of production accumulation - physical capital
We focus on physical capital because it is the most mobile factor of production. Physical capital flows across national borders through several channels. The largest is foreign direct investment, by which a foreign firm buys or builds a facility in another country. The second-largest channel is portfolio investment, in which investors from a foreign country purchase stocks or bonds. The remaining sources of capital flows are government grants and lending from banks and multinational donor agencies such as the World Bank. Of the $659 billion in private capital that flowed into developing countries in 2010, $248 billion was foreign direct investment
Physcial capital accumulation: Autarly vs. Open Economy
Autarky: Solow-model is holding there. Savings=Investment. The most important determinant of GDP growth is the saving rate.
Open economy: An economy is completely open to capital flows from abroad. Savings aren’t necessarily equal investments. Domestic investments can be now financed by foreign savings, whereas foreign investments can be financed by domestic savings.
What does determine openness?
Large volumes of goods and services and factors flowing between countries characterize openness. However, there must be always a reason to trade: comparative advantage, trade costs, etc.
Another way to determine openness is to assess whether the law of one price (LOP) holds:
- The same good will be sold for the same price in both markets.
- The LOP refers to the notion that the DEGREE OF INTEGRATION CAN BE ASSESSED BY MEASURING DIFFERENCES IN PRICES.
The closer are the prices of the SAME GOOD in two countries, the more integrated are their markets for goods (i.e trade).
Same principle applies for the trade with factors of production (factor price equalization H.O model?)
Important difference between Solow-model (autarky) and Open Economy. What are the main factors that determine the amount of accumulated capital and the total income level (GDP) in a country?
Our assumption of perfect openness to factor flows implies that the law of one price holds true: Factor prices in the country we are examining must be the same as factor prices in the rest of the world. We also assume that our country is SMOEC, which means that no matter what changes take place in our country, it has no influence on the world market equilibrium.
So, r=rw
WHAT DETERMINES FACTOR ACCUMULATION IN THE OPEN ECONOMY GIVEN PERFECT CAPITAL MOBILITY:
With perfect capital mobility, the capital/labor ratio depends on the world rental rate of capital. This result is important because in our previous analysis of growth and capital accumulation in a closed economy, the capital/labor ratio in a given country depends on domestic factors like the saving rate and the growth rate of the population (SOLOW-MODEL)
WHAT DETERMINES GDP PER CAPITAL IN THE OPEN ECONOMY GIVEN PERFECT CAPITAL MOBILITY:
We first substitute the level of capital per worker into the production function. What we see is that GDP/capita also depends on the world rental rate of capital + productivity level of an economy. In contrast, in the Solow model for a closed economy, the level of GDP per worker depends on the saving rate. A country that saves more will be richer in the steady state. But the saving rate does not appear anywhere in equation for GDP/capital in open economy. Thus, GDP per capita in the open economy will not be any higher in a country with a high saving rate than in a country with a low saving rate.
But! Don’t forget there’s still GNP
Still, countries with higher saving rates are better off than countries with lower saving rates.
GDP/capita in an open economy doesn’t depend on the saving rate in a country. Does this mean that countries with higher saving rates aren’t richer than countries with lower saving rates?
No! To see this, we have to look beyond GDP to GNP.
GNP measures income generated by the country’s citizens, regardless of the geographic location of the income.
Thus, although changes in the saving rate will not affect GDP, they will have an impact on GNP because they will affect the quantity of capital owned abroad. A country that saves more will own more capital in total (both owned by the citizens of this country at home and abroad) and consequently will earn more capital income, with the result that GNP will rise.
Although saving rate doesn’t have a direct influence on the GDP growth, there some very important implications of saving rate on GDP. What are these?
1) A country with a low saving rate, openness to capital flows should raise the GDP.
Capital that is not supplied domestically can be supplied from abroad. The same would hold true for any country that has a low level of capital—for example, a country in which a war or natural disaster destroyed part of the capital stock. If the economy is open to capital flows, then investment flowing into the country from abroad can produce growth in GDP per worker that is much more rapid than the country could produce with its own savings.
s low - K low - MPK high - higher incentive for foreign investments
2) For a country with a high saving rate, openness to capital flows will lower the level of GDP per worker, as capital will flow abroad to countries where its marginal product is higher.
s high - K high - MPK high - savings flowing abroad for a higher rate of return to capital
At first, this implication might seem to indicate that for a country with high saving, openness to capital flows is a bad thing. But this conclusion is incorrect. It can be shown algebraically that openness to capital flows will raise the level of GNP per worker in both high- and low-saving countries!!! Why? Recall the definition of GNP: the sum of all income earned by the FACTORS OF PRODUCTION owned by the residents of a given country. So, in case of low-saving country, citizens of this country living abroad would earn higher rental rates on capital invested in their home country. On the other hand, savings of a high-saving country savings will be invested in a foreign economy, thus increasing total income abroad, including income of this countrys’ citizens living abroad.
In this way, GNP of both high-saving country and low-saving will increase in an open economy.
Assessment of the free-capital flow model: no relationship between savings and investment. Does this assumption actually hold in the real world?
We assume that under perfect capital mobility there should be no particular relationship between savings and investments, as it was under autarky.
We now just the investment i.e the capital/labor ratio depends on the total factor productivity, wheres saving rate might depend on the time preference of consumers (future or present-oriented consumption).
The real data shows, however, a high correlation between investment and saving.
In order to measure the degree of capital market openness of a country, we use the measure, called SAVING RETETNTION COEFFICIENT, which refers to the fraction of the additional monetary unit of saving that is used for additional investment.
If saving retention rate=1,an economy is closed to free capital market flows. If saving retention=0, an economy is completely open to free capital market flows.
Openess and productivity: Productivity as another chanel through which openness affects economic growth (GDP/per capita)
We have already discussed a first possible channel through which openness might affect economic growth (making countries richer), i.e through physical capital accumulation. However, data showed that the assumption of perfect capital mobility doesn’t actually hold. In this way, the primary channel through which openness raises income per capita must be PRODUCTIVITY.
Openness and Productivity: Trade as a Form of Technology
The most important effect of trade on productivity is so obvious that it is easy to overlook: Trade makes a country more productive by allowing it to produce the things it is good at producing and then to sell them to other countries in return for things it is not as good at producing. From this perspective, trade is like the form of productivity enhancement.
Potential gains from trade arise whenever a country has a comparative advantage in producing some good relative to another country.
Openness and technological progress: trade as a technological innovation
- Trade works as a technological innovation (contributes to a higher level of technology) in two main ways :
1) Countries that are open to trade are more able to import existing technologies from abroad (technology transfer).
2) Trade expands the incentives for the creation of new technologies (also through competitiveness)
- Technology transfers take place through several channels
facilitated by openness, among them:
1) Foreign direct investment (FDI) allows for the transfer of technology along with capital (a firm building a factory in another country will transfer technology along with capital)
2) GVC (global value chain) integration enables technological change by importing tech-intensive intermediate inputs or capital goods.
As a measure of the importance of technology transfer in raising a country’s level of technology, one study investigated what fraction of technological progress in each of the OECD countries could be attributed to ideas that originated abroad, compared with ideas produced domestically.
In addition to facilitating technology transfer, a second way in which openness contributes to a higher level of technology is by expanding the incentives for the creation of new technologies.
The primary motivator for firms or entrepreneurs to invest in research and development is the prospect of the profits they will earn by deploying a successful invention. Naturally, the larger the market in which a new invention will be used or a new product sold, the higher the profits accruing to the inventor. This lure of higher profits will give a greater incentive to R&D spending in an economy that is able to export its products.
Opennes and efficiency: productivy differences
Productivity differences result from the EFFICIENCY with which countries use the available technology and factors of production.
There is good reason to believe that the openness of an economy makes an important contribution to the level of efficiency in production.
The presence of monopolies is one source of inefficiency—specifically, monopoly leads to the misallocation of factors of production. An important effect of trade is that it weakens the monopoly power of domestic firms, thus raising efficiency. A similar effect of trade is to allow the firms in a country to take advantage of economies of scale by giving them access to a larger market for their output.
In addition to these effects on efficiency, there is good evidence that foreign competition has a bracing effect on domestic firms. Over and over again, we see examples of firms being exposed to competition from abroad and then raising their efficiency in production.
