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Classical Trade Theory. Globalization: It’s the Factor Prices!. 2 x 2 x 2 Model. Two goods, two countries, two factors of production: neat analytical framework

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### Classical Trade Theory

Globalization: It’s the Factor Prices!

2 x 2 x 2 Model

- Two goods, two countries, two factors of production: neat analytical framework
- General competititve equilibrium: markets clear, resource constraints and optimization of production (marginal productivity conditions)
- Relative prices are given
- Country is better off when it moves to a higher indifference curve. This is the economic meaning of “welfare”.

Hecksher – Ohlin Theorem

- Specialization and comparative advantage: works out the Ricardian theory of comparative advantage in a full general equilibrium framework with capital and labor, abandons fixed coefficient production function
- Result: countries that are relatively labor abundant should specialize in relative labor intensive goods; countries that are capital abundant should specialize in capital abundant goods.

Factor Price Equalization Theorem

- Trade is a substitute for movement of factors of production: this is a fundamental reason for trade agreements such as NAFTA.
- If two countries move from autarky to free trade, wages will fall in the capital abundant country and rise in the labor abundant country, while rental rates will rise in capital abundant country and fall in labor abundant country

Stolper-Samuelson Theorem

- Tariffs and relative returns to factors of production
- A tariff on a labor intensive good (or a rise in its price) will lead to an increase in wages relative to rental rates on capital
- A tariff on a capital intensive good will lead to a fall in wages relative to capital

Rybczynski Theorem

- Effect of changes in supply of labor or capital
- An increase in capital in a country will lead to an expansion in the production of the capital intensive good and a contraction in the production of the labor-intensive good
- An increase in labor will lead to expansion of labor-abundant good and a contraction of the capital-abundant good.

General Equilibrium Issues

- What about a third factor of production, land, and production of agricultural goods as well as capital and labor intensive manufactured goods?
- Example: cut in tariffs on agriculural goods. Labor is freed from farms and there is migration to cities, so wages should fall. But with cheaper food, wages may actually increase.
- Skilled labor and increasing returns: skilled labor actually goes to places where there are already pools of skilled labor. Not just for social reasons! Productivity of good surgeons higher with good nurses, internists. Skilled labor ofen compliments, rather than substitutes, other skilled labor.

Measurement of Capital Mobility: What is Capital?

- Interest Parity Theorem (relating to issue of independent monetary policy).
- Feldstein-Horioka Paradox: savings and investment correlations
- Arbitrage and claims on capital (k and k*)
R = R* = f’(k) + ln[Q(t+1)]-ln[Q(t)]=

f’(k*) + ln[Q*(t+1)]-ln[Q(t)]

Q and Q*: real share prices of claims on capital, f’(k) and f’(k*) marginal productivity of capital

Issue of Growth and Productivity:Growth Is All That Matters

- Solow model and sources of growth
log(Y) = ln(A) + alpha *ln(K) + (1-alpha)ln(L), this is Cobb-Douglas function in logarithmic form

If A is constant, we can describe growth,

Diff(y) = alpha Diff(k) + (1-alpha) Diff(l),

Where y is the log of Y, k log of K, l log of L,

And Diff is the difference operator.

Solow Residuals

- Is A really constant? We call Diff(a), the total factor productivity, or TFP effect.
- We can rewrite the growth equation
Diff(y) = Diff(a) + alpha Diff(k) + (1-alpha) Diff(l).

According to many studies, the TFP effect explains more than half of growth of industrial countries

Krugman Controversy

- Asian miracle: fast growth in the NIC’s or Gang of Four, for over 10 years.
- Krugman said it was due to forced saving and investment, long hours of work, little of the growth can be explained by the TFP effect.
- So if we are forced to saving 40% of our income, and get only two weeks off a year, of course a country will grow.

Real Business Cycle Theory

- Kydland-Prescott and macroeconomic fluctuations in US GDP for over a century.
- Measured shocks to GDP productivity as the Solow residual.
- They concluded that over 80 percent of the variance of real GDP is due to real productivity shocks, not due to demand factors such as fiscal policy or monetary policy. Hard anti-Keynesian theory.

Emerging Markets and RBC Theory

- Terms of trade shocks drive GDP cycles, not productivity shocks
- Real exchange rate and the terms of trade
- Harberge-Laursen-Metzler Effect vs classical effect of a devaluation (change in terms of trade

Devaluation Effects

- Elasticity pessimism vs. optimism
- Income distribution effects
- Effects on imported inputs: the contractionary effects of a devaluation
- J-curve effects

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