Is lowering tariff and adopting an open policy a good thing? Is a Free Trade Agreement (FTA) good for our country? Someone commented that since in most countries, including the developed ones, protectionism in the forms of tariff, subsidies and quota still exists, it can therefore be concluded that protectionism is in fact good for us. This is a good argument but I would like to put forth my views here to show that an open market actually benefits everyone.
Take the example of India. India is a great country. But until the mid 1990s, it was essentially a closed and protected economy. Even up to the early 90s, it was producing cars that looked like Morris Minor of the 60s. Well, since the market was protected, there was no incentive to innovate and improve the design. It was still saleable in the domestic market mainly because there was no other choice since the market was protected, but outside the country, who would want to buy a car with a design and technology probably 20 years behind time? It could not compete against the outside world even though it has a highly educated population.
ManMohan Singh started the economic reforms in the 90s and you can witness the growth rate has shot up and within a short span of years, India has become an up and coming economy. It is now a major outsourcing destination for the West especially in IT software technology.
Let us now take a hypothetical case. Let’s say that I operate a fan factory in our country and let’s assume that the fan market is a protected market. I would enjoy the protection because my fan is crude and old fashioned and though I know it, I have no incentive to improve.
I would be contented with that design since it would be selling well in the country through protection. But my fans could not be exported because nobody outside our country will buy it. But once the market is opened up, I would have no choice but to source for better parts and better designs if I want to compete with the imports. I would have no choice but to make my company more efficient. In doing so, my products and services improve and if they can compete with the imports, they will definitely be good enough for the export market.
I will find that now my improved fans can have a much bigger market than before. The higher revenues earned will enable me to move up to making higher end products such as air-conditioners, fridges and so on. That was in fact how many of our local electrical companies went through. Of course, if I have adopted a tidak apa attitude when the market is opened up and not improved myself, my fan factory would not have stood a chance, and it would have folded up.
China's rise
China started its reform in the 80s. Before that, China was producing many goods and was probably self sufficient in many ways. But their products were crude, bulky, ancient looking, and technologically behind time. Yes, they were producing radios and TVs but these products were unable to compete with the outside world even with very cheap pricing. But once China opened up, there was no turning back. They are now the top off-shoring destination in the world. It is no exaggeration to say that now every company in the Fortune 500 list has a presence in China. Looking around myself, my HP notebook is made in China, my Motorola handphone is also made in China, and so are a growing numbers of products in my home and yours. Its own products are also fast catching up with the West in both design and technology.
Since China joined the World Trade Organisation in December 2001, in the words of three times Pulitzer winner Thomas Friedman, the whole world now has to run faster because China is running very fast.
US and the rest of the developed nations have to be more innovative and move up to a higher level because the lower rungs of the ladders are fast being occupied by China and the little dragons and tigers. From a mainly off-shore manufacturing centre, China has now moved up to designing products. In the not so distant future, I am certain it will start to invent ideas and move to the forefront of technology
.
So, the world has to run faster. Any nation still idling and moving in low gears will find itself being overtaken by other countries. This competition is good for mankind as it helps to hasten technological advances and raise the standard of living for the whole world.
Technological advances move with such lightning speed that sometimes we really feel behind time. In this digital world, what is sold today becomes obsolete in a year or two. An example is the computers chips which improved so fast that 286, 386, 486, Pentium I, and now Pentium II are considered obsolete, all within a decade. In the present era, it is much easier for people of an open economy to have access to these new advances and innovation.
Even Starbucks and Coffee Beans bring changes. These chains and their franchisees have set up so many outlets that it is now so convenient for anyone with a wi-fi notebook or PDA to be connected to the rest of the world while sipping a cup of coffee in these outlets. Their presence has helped create a new industry of local cafes and eateries with wi-fi facilities. If we did not allow them to come in a few years ago, I am not sure whether we would still have these local cafes operating along the lines of Starbucks. These changes help to bring in technological changes and new ideas, and with these new ideas, new businesses and industries will grow.
A certain form of protection maybe necessary in the initial stage of developing an industry. Once the industry has found its footing, opening up gradually will help the industry become more efficient, competitive and advanced technologically.
People factor
A main factor to be considered is of course the people. If the people are hardworking and adaptive, willing to accept new ideas and learn, then an open economy will stimulate the country to grow faster. If on the other hand, the people have a ‘tidak apa’ attitude, then they may find themselves overwhelmed by the external forces and become marginalised. Many countries are afraid of opening up precisely because the leaders are not sure whether their people in certain sectors are ready.
However, it is my opinion that too much protection is bad for the people. The people become dependent, afraid of changes and not receptive to new ideas. They cannot think outside the box. In order to make them adaptive, they must face new challenges and be innovative. So opening up the economy will have this effect of pushing the people to become more efficient and adaptive.
Economist Milton Friedman rated Hong Kong as the freest of all economies. It is no wonder that Hong Kong has one of the most disciplined, hardworking and innovative workforce. With practically no natural resources, it has weathered one challenge after another to emerge stronger each time.
Another advantage for opening up is that there would be an increase of FDI. Mexico is an example. The FDI into Mexico increased three times after the signing of NAFTA (North American Free Trade Agreement). Singapore and Australia too experienced an increase in FDI after their FTA with the US. Any increase in FDI would be welcomed here because it could jumpstart our economy again.
Finally, an open economy would have a corrective effect on some of the anomalies that our economy may be facing because of the implementation of the New Economic Policy (NEP).
Wednesday, January 12, 2011
Theory Of Open Economy
Theory Of Open Economy - Presentation Transcript
- 32 A Macroeconomic Theory of the Open Economy
- Key Macroeconomic Variables in an Open Economy
- An open economy is one that interacts freely with other economies around the world.
- The important macroeconomic variables of an open economy include:
- net exports
- net foreign investment
- nominal exchange rates
- real exchange rates
- SUPPLY AND DEMAND FOR LOANABLE FUNDS AND FOR FOREIGN-CURRENCY EXCHANGE
- The model takes the economy’s GDP as given.
- The model takes the economy’s price level as given.
- The Market for Loanable Funds
- S = I + NCO
- At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net capital outflows.
- The Market for Loanable Funds
- The supply of loanable funds comes from national saving (S).
- The demand for loanable funds comes from domestic investment ( I ) and net capital outflows ( NCO ).
- The Market for Loanable Funds
- The supply and demand for loanable funds depend on the real interest rate .
- A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied.
- The interest rate adjusts to bring the supply and demand for loanable funds into balance.
- Figure 1 The Market for Loanable Funds Copyright©2003 Southwestern/Thomson Learning Quantity of Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Equilibrium real interest rate
- The Market for Loanable Funds
- At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.
- The Market for Foreign-Currency Exchange
- The two sides of the foreign-currency exchange market are represented by NCO and NX .
- NCO represents the imbalance between the purchases and sales of capital assets.
- NX represents the imbalance between exports and imports of goods and services.
- The Market for Foreign-Currency Exchange
- In the market for foreign-currency exchange, U.S. dollars are traded for foreign currencies.
- For an economy as a whole, NCO and NX must balance each other out, or:
- NCO = NX
- The price that balances the supply and demand for foreign-currency is the real exchange rate.
- The Market for Foreign-Currency Exchange
- The demand curve for foreign currency is downward sloping because a higher exchange rate makes domestic goods more expensive.
- The supply curve is vertical because the quantity of dollars supplied for net capital outflow is unrelated to the real exchange rate.
- Figure 2 The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate
- The Market for Foreign-Currency Exchange
- The real exchange rate adjusts to balance the supply and demand for dollars.
- At the equilibrium real exchange rate, the demand for dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad.
- EQUILIBRIUM IN THE OPEN ECONOMY
- In the market for loanable funds , supply comes from national saving and demand comes from domestic investment and net capital outflow.
- In the market for foreign-currency exchange , supply comes from net capital outflow and demand comes from net exports.
- EQUILIBRIUM IN THE OPEN ECONOMY
- Net capital outflow links the loanable funds market and the foreign-currency exchange market.
- The key determinant of net capital outflow is the real interest rate.
- Figure 3 How Net Capital Outflow Depends on the Interest Rate Copyright©2003 Southwestern/Thomson Learning 0 Net Capital Outflow Real Interest Rate Net capital outflow is negative. Net capital outflow is positive.
- EQUILIBRIUM IN THE OPEN ECONOMY
- Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets.
- As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.
- Figure 4 The Real Equilibrium in an Open Economy Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Net capital outflow, NCO Supply Supply Demand Demand r r E
- HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY
- The magnitude and variation in important macroeconomic variables depend on the following:
- Government budget deficits
- Trade policies
- Political and economic stability
- Government Budget Deficits
- In an open economy, government budget deficits . . .
- reduce the supply of loanable funds,
- drive up the interest rate,
- crowd out domestic investment,
- cause net foreign investment to fall.
- Figure 5 The Effects of Government Budget Deficit Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Demand Demand NCO S S r 2 S S r 2 B E 1 r r A 1. A budget deficit reduces the supply of loanable funds . . . 2. . . . which increases the real interest rate . . . 4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . . 5. . . . which causes the real exchange rate to appreciate. 3. . . . which in turn reduces net capital outflow. E 2
- Government Budget Deficits
- Effect of Budget Deficits on the Loanable Funds Market
- A government budget deficit reduces national saving, which . . .
- shifts the supply curve for loanable funds to the left, which . . .
- raises interest rates.
- Government Budget Deficits
- Effect of Budget Deficits on Net Foreign Investment
- Higher interest rates reduce net foreign investment.
- Effect on the Foreign-Currency Exchange Market
- A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency.
- This causes the real exchange rate to appreciate.
- Trade Policy
- A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports.
- Tariff : A tax on an imported good.
- Import quota : A limit on the quantity of a good produced abroad and sold domestically.
- Trade Policy
- Because they do not change national saving or domestic investment, trade policies do not affect the trade balance.
- For a given level of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same.
- Trade policies have a greater effect on microeconomic than on macroeconomic markets.
- Trade Policy
- Effect of an Import Quota
- Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency.
- This leads to an appreciation of the real exchange rate.
- Trade Policy
- Effect of an Import Quota
- There is no change in the interest rate because nothing happens in the loanable funds market.
- There will be no change in net exports.
- There is no change in net foreign investment even though an import quota reduces imports.
- Trade Policy
- Effect of an Import Quota
- An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports.
- This offsets the initial increase in net exports due to import quota.
- Figure 6 The Effects of an Import Quota Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds (b) Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate Supply Supply Demand NCO D E r r D 3. Net exports, however, remain the same. 2. . . . and causes the real exchange rate to appreciate. E 2 1. An import quota increases the demand for dollars . . .
- Trade Policy
- Effect of an Import Quota
- Trade policies do not affect the trade balance.
- Political Instability and Capital Flight
- Capital flight is a large and sudden reduction in the demand for assets located in a country.
- Political Instability and Capital Flight
- Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.
- If investors become concerned about the safety of their investments, capital can quickly leave an economy.
- Interest rates increase and the domestic currency depreciates.
- Political Instability and Capital Flight
- This increased net capital outflow.
- The demand for loanable funds in the loanable funds market increased, which increased the interest rate.
- This increased the supply of Rupee in the foreign-currency exchange market.
- Figure 7 The Effects of Capital Flight Copyright©2003 Southwestern/Thomson Learning (a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow Real Interest Rate Real Interest Rate (c) The Market for Foreign-Currency Exchange Quantity of Rupee Quantity of Loanable Funds Net Capital Outflow Real Exchange Rate r 1 r 1 D 1 Demand S Supply NCO 1 D 2 E S 2 NCO 2 1. An increase in net capital outflow. . . 3. . . . which increases the interest rate. 2. . . . increases the demand for loanable funds . . . 4. At the same time, the increase in net capital outflow increases the supply of pesos . . . 5. . . . which causes the peso to depreciate. r 2 r 2 E
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