Macroeconomics II: Net-Export, International trade

and real exchange rate

Dániel Baksa

ELTEcon

ELTEcon
 Macroeconomics II
Outline for this week:
Dániel Baksa

Introduction
International trade: Ricardian model
Comparison of competitive trade theories: richness of Real exchange rate
endowment (Hecksher-Ohlin), comparative advantage Firms
Households
(Ricardian), love of varieties (Increasing return to scale) Export and import
Role of real exchange rate in general
equilibrium models
Examples for export and import in general equilibrium
models
Readings:
Obstfeld, M & Rogoff, K (1996): Foundations of
International Macroeconomics, Chapter 4

2
 Macroeconomics II
!!!!!!!!!!!!!!!!!!!
Dániel Baksa

Textbooks Introduction

Obstfeld, M & Rogoff, K (1996): Foundations of Ricardian model

Real exchange rate

International Macroeconomics, Chapter 4 Firms
Households
Martin Uribe - Stephanie Schmitt-Grohé (USG, 2016): Export and import
Lectures in Open Economy Macroeconomics: Chapter in general
equilibrium models
2-3
Carl E. Walsh (CW, 2003): Monetary Theory and Policy
Jordi Galı́ (JG, 2015): Monetary Policy, Inflation and
the Business Cycle: An Introduction to the New
Keynesian Framework and Its Applications

3
 Macroeconomics II

Dániel Baksa

Introduction

Ricardian model

Real exchange rate

Firms
Is it relevant? Households

Export and import

in general
equilibrium models

4
 Macroeconomics II

Dániel Baksa

Introduction

Ricardian model

Real exchange rate

Yes, until now do not understand the Firms
Households

nature of international trade ... Export and import

in general
equilibrium models

5
 Macroeconomics II

Dániel Baksa

Introduction

Ricardian model

Real exchange rate

... these results are implicitly involved to Firms
Households

open economy DSGE/RBC models Export and import

in general
equilibrium models

6
 Macroeconomics II
From the last lectures
Dániel Baksa

Introduction

Consumption is pro-cyclical, positively correlated with Ricardian model

GDP, persistent (solved) Real exchange rate

Firms
Investment is pro-cyclical, volatility 2-3 times higher Households

Export and import

than GDP, persistent (solved) in general
equilibrium models
Export and import is pro-cyclical, positively
correlated and more volatile than GDP
Trade-balance and current account counter-cyclical, and
persistent (partly solved, with OLG better)

7
 Macroeconomics II
Plan for today:
Dániel Baksa

Introduction

Ricardian model
1 Need to understand core motivation: who, when trade Real exchange rate
Firms
(or export, import): Ricardian model Households

2 The equilibrium price determination: terms-of trade and Export and import
in general
real-exchange rate equilibrium models

3 Export and import in general equilibrium models (many

extension, only the concepts)

8
 Macroeconomics II
3 main theories
Dániel Baksa

Introduction

Ricardian model
1 Hecksher-Ohlin: relative richness of endowments
Real exchange rate
(capital and labor) Firms
Households
2 Ricardian: relative productivity Export and import
in general
3 Krugman: love of varieties, increasing return on newly equilibrium models

established industries
First two can be implemented in the same framework, third
is better in growth theory.

9
 Macroeconomics II
Ricardian model: Firms (1)
Dániel Baksa

Introduction

z ∈ [0; 1] products in domestic and foreign economy: Ricardian model

Real exchange rate

q(z) level of production Firms
Households
Need labor input for production (labor does not flow Export and import
across countries): L domestic, L∗ foreign in general
equilibrium models
L(z) L∗ (z)
a(z) = q(z) domestic labor, a∗ (z) = q ∗ (z) foreign labor
wa(z) and w ∗ a∗ (z) the marginal cost, w and w ∗ real
wages

10
 Macroeconomics II
Ricardian model: Firms (2)
Dániel Baksa

Domestic economy produces z if:

p(z) = wa(z) < w ∗ a∗ (z) = p ∗ (z) Introduction

Ricardian model
So the relative wages express the relative productivity Real exchange rate
differentials: Firms
Households

w a∗ (z) Export and import

in general
< = A(z) equilibrium models
w∗ a(z)

So those z produced abroad where:

w
> A(z)
w∗
A(·) is negative function of z: domestic country
produce more products if and only if the production
cost (real wage) is lower.
11
 Macroeconomics II
Ricardian model: Households (1)
Dániel Baksa

Households maximizes their lifetime utilities:

∞
X Introduction
U= β t ln Ct Ricardian model

t=0 Real exchange rate

Firms
Households
Where the consumption basket consists continuum
Export and import
good: in general
equilibrium models
Z 1 
Ct = exp ln ct (z)dz
0

Cost minimization:
Z 1
min pt (z)ct (z)dz
ct (z) 0

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 Macroeconomics II
Ricardian model: Households (2)
Dániel Baksa

Lagrangian:
Z 1  Z 1 
L = min pt (z)ct (z)dz + λt Ct − exp ln ct (z)dz Introduction
ct (z) 0 0
Ricardian model

FOCs: Real exchange rate

Firms
Z 1  Households
1
ct (z) : pt (z) − λt exp ln ct (z)dz =0 Export and import
0 ct (z) in general
equilibrium models

Rearranging:
λt
ct (z) = Ct
pt (z)

Plug it back to the basket:

Z 1   
λt
Ct = exp ln Ct dz
0 pt (z)

13
 Macroeconomics II
Ricardian model: Households (3)
Dániel Baksa
And we can express λt :
Z 1   
1
1 = λt exp ln dz
0 pt (z) Introduction
Z 1    Ricardian model
1 1
= exp ln dz Real exchange rate
λt 0 pt (z) Firms
Z 1 Households

− ln λt = − ln pt (z)dz Export and import

0 in general
Z 1  equilibrium models

λt = exp ln pt (z)dz
0

λt is an aggregate price index, then lets call it Pt

Since we use simple equations we can express the range
of goods based on aggregate categories:
Z zt2 Z zt2
Pt
pt (z)ct (z)dz = pt (z) Ct dz = (zt2 − zt1 )Pt Ct
zt1 zt1 pt (z)
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 Macroeconomics II
Ricardian model: Equilibrium
Dániel Baksa
World economy should satisfy:
Pt (Ct + Ct∗ ) = wt Lt + wt∗ L∗t
Introduction
where the LHS express the all consumed product, RHS
Ricardian model
all earned income Real exchange rate
Assuming the domestic economy produce [0; z] interval Firms
Households
of goods: Export and import
in general
zt Pt (Ct + Ct∗ ) = wt Lt equilibrium models

where we used the properties of consumption basket

Combining these two equilibrium condition:
w t Lt
= wt Lt + wt∗ L∗t
zt
zt L∗t L∗t
 
wt
= = B zt ;
wt∗ 1 − zt Lt Lt
where z positive function of B(·)
15
 Macroeconomics II
Ricardian model: Equilibrium - graph
Dániel Baksa

Introduction
B(z,L*/L) Ricardian model

Real exchange rate

A(z) Firms
Households

Export and import

in general
equilibrium models

w/w*

z 1

16
 Macroeconomics II
Ricardian model: Comparative static (1)
Dániel Baksa

Increasing foreign labor supply (shifts B(·) left):

Introduction
Foreign labor supply increase, and foreign more
Ricardian model
competitive
Real exchange rate
zt+1 < zt , so more produced by foreign economy: Firms
Households
domestic economy imports more from abroad, and Export and import
in general
export less equilibrium models

More labor, push down the foreign real wages, and

some industries on the margins move to abroad
The domestic average export price increase, the
domestic import price decrease
Domestic terms-of-trade improves, foreign
terms-of-trade declines

17
 Macroeconomics II
Ricardian model: Comparative static (1) - graph
Dániel Baksa

Introduction
B(z’,L*’/L)
B(z,L*/L) Ricardian model

Real exchange rate

A(z) Firms
Households

Export and import

w'/w*’ in general
equilibrium models

w/w*

1
z' z

18
 Macroeconomics II
Ricardian model: Comparative static (2)
Dániel Baksa

Increasing foreign productivity (pushes down A(·)): Introduction

Ricardian model
Foreign wages increase (shifts A(·) down), the domestic
Real exchange rate
relatively declines Firms
Households
zt+1 < zt , so more produced by foreign economy: Export and import
domestic economy imports more from abroad, and in general
equilibrium models
export less
Domestic terms-of-trade improves: domestic prices
relatively increase
Real wages: both increase, but foreign relative wages
improve

19
 Macroeconomics II
Ricardian model: Comparative static (2) - graph
Dániel Baksa

Introduction
B(z,L*/L) Ricardian model
A(z)
A’(z) Real exchange rate
Firms
Households

Export and import

in general
equilibrium models

w/w*

w'/w*’

z' z 1

20
 Macroeconomics II
Ricardian model and others
Dániel Baksa

Introduction

Comparative advantage explain the countries Ricardian model

specialization Real exchange rate

Firms
By increasing productivity the domestic economy Households

exports more Export and import

in general
Ricardian model assumes full specialization that is not equilibrium models

realistic
Focusing differentiated goods: tradable and
non-tradable production

21
 Macroeconomics II
Two sector (1)
Dániel Baksa

Tradable production
Introduction

YtT = AT T T Ricardian model

t F (Kt−1 , Lt )
Real exchange rate
ytT = AT T
t f (kt−1 )
Firms
Households

Export and import

where we can normalize with LT
t
in general
equilibrium models
Non-tradable production

YtN = AN N N
t G (Kt−1 , Lt )
ytN = AN N
t g (kt−1 )

where we can normalize with LN

t

22
 Macroeconomics II
Two sector (2)
Dániel Baksa

Introduction

Capital is from the same tradable products Ricardian model

Real exchange rate

Capital, labor could freely move among sectors Firms
Implies the same factor price Households

Export and import

Capital could move across countries (the rental fee in general
function of real interest rate) equilibrium models

Two different products, we need a real price (p) that

makes them comparable
Solving the profit-maximization problem

23
 Macroeconomics II
Two sector (3)
Dániel Baksa

Demand functions and using Euler theorem:

Introduction
0 T
AT
t f (kt−1 ) = r Ricardian model
 
AT
t
T
f (kt−1 ) − f 0 (kt−1
T T
)kt−1 = wt Real exchange rate
Firms
Households
0 N
pt AN
t g (kt−1 ) = r Export and import
  in general

pt AN
t
N
f (kt−1 ) − g 0 (kt−1
N N
)kt−1 = wt equilibrium models

Deriving the factor prices and inputs

1 r exogenous from financial market
2 k T from the first equation
3 with k T the w from the second equation
4 divide the last two and plug the w and r , express k N
5 from the third with k N express p

24
 Macroeconomics II
Two sector (4)
Dániel Baksa

Assuming constant rental fee, Cobb-Douglas

technologies, 1 − αT traded income share, 1 − αN
non-traded income share
Introduction
Approximation (log-linearization): Ricardian model

Real exchange rate

ÂT T T T
t + α k̂t−1 = αT k̂t−1 + (1 − αT )ŵt
Firms
Households

p̂t + ÂN N N N
t + α k̂t−1 = αN k̂t−1 + (1 − αN )ŵt
Export and import
in general
equilibrium models

So the real wages:

ÂT
t = (1 − αT )ŵt
p̂t + ÂN
t = (1 − αN )ŵt

Substitute out real wage:

1 − αN T
p̂t = Â − ÂN
1 − αT t t

25
 Macroeconomics II

Dániel Baksa

Introduction

Ricardian model

Real exchange rate

Non-traded technology decrease the Firms
Households

relative price, depends income shares ... Export and import

in general
equilibrium models

26
 Macroeconomics II
Households (1)
Dániel Baksa

Introduction

Ricardian model

In the households maximization problem we distinct two Real exchange rate

Firms
step: Households

1 Aggregate level decision: as before utility maximization Export and import

in general
over its lifetime equilibrium models
2 Combining the optimal level traded and non-traded
products (do it now)

27
 Macroeconomics II
Households (2)
Dániel Baksa
Assuming in the first step we choose the optimal level
of total consumption from the following problem:
Vt = U(Ct ) + βEt Vt+1 Introduction

Ricardian model
Now the households need to decide the combination of
Real exchange rate
traded and non-traded goods for the consumption Firms
Households
basket:
Export and import
 θ−1
 θ
θ−1 θ−1
in general
1 1 equilibrium models
Ct = γ θ CtT θ + (1 − γ) θ CtN θ

where θ = 1 gives the Cobb-Douglas function.

Cost-minimization (consistent with the aggregate level
optimization):
L = Pt Ct − CtT − pt CtN +
 θ−1
 θ
θ−1 θ−1
!
1 1
T N
+ λt γ θ Ct θ + (1 − γ) θ Ct θ − Ct
28
 Macroeconomics II
Households (2)
Dániel Baksa

FOCs:

Ct : Pt − λ t = 0 Introduction
1 1 −1 Ricardian model
CtT : −1 + λt Ct γ θ θ CtT θ =0
Real exchange rate
1 1 − θ1 Firms
CtN : −pt + λt Ctθ (1 − γ) θ CtN =0 Households

Export and import

in general
And the demands for traded and non-traded goods: equilibrium models

 −θ
1
CtT = γ Ct
Pt
 −θ
pt
CtN = (1 − γ) Ct
Pt

An increase in pt decrease the demand for non-traded

goods:
29
 Macroeconomics II
Households (3)
Dániel Baksa

Using the demand functions we can express the price

index if we plug back to the consumption basket:
Introduction
" # θ
1 θ−1 1 N θ−1 θ−1 Ricardian model
Ct = γ θ CT θ + (1 − γ) θ Ct θ
t
Real exchange rate
  θ Firms
! θ−1 ! θ−1 θ−1
1
−θ
θ pt
−θ
θ Households
 θ1 1
 
Ct = γ γ Ct + (1 − γ) θ (1 − γ) Ct


Pt Pt Export and import
in general
  θ equilibrium models
−θ ! θ−1 −θ ! θ−1 θ−1
 θ1 1 θ 1 pt θ
 
1 = γ γ + (1 − γ) θ (1 − γ)


Pt Pt

h i 1
1−θ 1−θ
Pt = γ + (1 − γ)pt

Setting θ = 1 we can get the Cobb-Douglas case:

Pt = 1γ pt1−γ

30
 Macroeconomics II
Real-exchange rate
Dániel Baksa

Assuming domestic and foreign economies has the same

preferences over the traded and non-traded goods, so
the following price indices: Introduction

Ricardian model
Pt = 1γ pt1−γ
Real exchange rate
Pt∗ = 1γ pt∗ 1−γ Firms
Households

Export and import

where 1 is the same tradeable price, pt ,pt∗ are the in general
equilibrium models
non-tradable prices.
Real exchange rate (definition):
1−γ
P∗ pt∗

Zt = t =
Pt pt

Taking logs:

Ẑt = (1 − γ) (p̂t∗ − p̂t )

31
 Macroeconomics II
Balassa-Samuelson effect
Dániel Baksa

Plugging back the firms equations for prices: Introduction

Ricardian model
 
1 − αN T ,∗ N,∗ 1 − αN T N Real exchange rate
Ẑt = (1 − γ) Â − Ât − Â + Ât
1 − αT t 1 − αT t Firms
Households
 
1 − αN  T ,∗ T
 
N,∗ N Export and import
= (1 − γ) Ât − Ât − Ât − Ât in general
1 − αT equilibrium models

Increasing traded sector technology appreciate the real

exchange rate, increase the domestic non-traded prices
E.g.: Central-European post-socialist countries started
converge to a higher productivity levels

32
 Macroeconomics II

Dániel Baksa

1 2
P EU R "S j=EU R j
Real Exchange Rates Z j = Pj in Central Europe, Z1996M01 = 100
110
Hungary
Czech Republic Introduction
Poland
100 Ricardian model

Real exchange rate

Firms
90
Households

Export and import

in general
80
equilibrium models

70

60

50
1996:01 1998:01 2000:01 2002:01 2004:01 2006:01 2008:01 2010:01 2012:01 2014:01 2016:01

33
 Macroeconomics II

Dániel Baksa

Introduction

Ricardian model

Real exchange rate

Nice, but take away??? Firms

Households

Export and import

in general
equilibrium models

34
 Macroeconomics II
Export, import in general (1):
Dániel Baksa

Introduction

Ricardian model
No best way, many concepts and Real exchange rate
depends on a given country Firms
Households
depends on a question Export and import
depends on our abstraction in general
equilibrium models
Common feature:
relative price changes
GDP identitiy should satisfies

35
 Macroeconomics II
Export, import in general (2):
Dániel Baksa

GDP equation Introduction

Ricardian model
GDPt = Ct + It + Gt + EXt − IMt Real exchange rate
Firms
Households
where each demand components consist Export and import
traded/non-traded or domestic/imported part. in general
equilibrium models
Depends on our assumption, total production uses
domestic capital, labor and imported goods
GDP is value added, so it not contains other country
goods (import)
Import part of the production function or it is part of
each expenditure components

36
 Macroeconomics II
Import:
Dániel Baksa
1 Import as production input
Yt = F (Kt−1 , Lt , IMt )
Introduction
and the GDP
Ricardian model
GDPt = Yt − PtIM IMt Real exchange rate
Firms
Households
and GDP identity:
Export and import
in general
GDPt = Ct + It + Gt + Xt − PtIM IMt equilibrium models

2 Import is part of each expenditure components:

GDPt = PtC Ct (CtD , CtIM ) + PtI It (ItD , ItIM ) +
+ PtG Gt (GtD , GtIM ) + PtX Xt (XtD , XtIM ) − PtIM IMt
where
each components function of domestic product and
imported
has different price indices, because different amount of
import 37
 Macroeconomics II
Export:
Dániel Baksa

1 Explicit model for two country (small-small, small-big,

big-big economies): domestic export is same with the Introduction

foreign import Ricardian model

Real exchange rate

2 Many models use simplification and assumes a Firms
Households
CES-type demand function: Export and import
in general
X −θ equilibrium models
 
Pt
Xt = Yt∗
Zt

where the PtX domestic export price, Zt real exchange

rate, Yt∗ other foreign GDP
These two consistent with the theories above: relative price
changes determines export/import

38
 Macroeconomics II

Dániel Baksa

Introduction

Ricardian model

Real exchange rate

Thank you for your attention! Firms

Households

Export and import

in general
equilibrium models

39