Archive for December 2nd, 2009

Evolution of Trade Theory

December 2, 2009

Though most must have read this Krugman paper, those who have not should make it a priority. It is amazing the way Krugman writes on economics. It is just so many things in such a simple fashion.

This paper has been written for celebrating Alan Deardoff’s career. Alan Deardoff is an international trade professor at Univ of Michigan.

In this paper, Krugman tells you about the development of  Trade Theory.

I like to begin classes on international trade by telling students that there are two basic explanations of international trade. The first is comparative advantage, which says that countries trade to take advantage of their differences – a concept that lay at the heart of Alan Deardorff’s beautiful, classic paper “The general validity of the law of comparative advantage” (1980). The second is increasing returns, which says that countries trade to take advantage of the inherent advantages of specialization, which allows large-scale production – which is what the “new trade theory” was all about.

I also like to illustrate these concepts from everyday experience. Everyday illustrations of comparative advantage are, of course, a staple of introductory textbooks – why sports stars shouldn’t mow their own lawns, etc. But it’s equally easy to illustrate the role of increasing returns. Even if two people are equally suited for the roles of rocket scientist and brain surgeon, it makes sense for one to specialize on surgery and the other on rockets, because mastering either skill takes years of study, and it would be wasteful for both people to master both disciplines.

The new trade theory is what Krugman helped develop.

He then says there are three eras of international trade. Era I before World War I was where you saw comparative adv work. Era II was after WWII where we saw increasing returns work. In Era III now, we again see a comeback for comparative adv. 

But he now thinks both comparative adv and increasing returns are important

Over the past century world trade has gone through a great arc. At the beginning of the century trade was primarily between countries with very different resources exporting very different goods, so that it seemed to be a comparative advantage world. By the 1980s trade was largely between countries with similar resources exporting similar goods, so that economists turned to increasing-returns models to make sense of what they say. But today, with the rise of China and other low-wage economies, we seem once again to be in a comparative advantage world, in which countries with very different resources export very different goods.

What I’ve argued in this paper, however, is that even during comparative-advantage eras increasing returns in the form of localized external economies plays a significant role. In fact, the same eras in which comparative advantage seems to have ruled international trade are also the eras in which increasing returns has seemed to exert its strongest influence on intra-national economic geography. And this observation isn’t irrelevant even in the trade context: gains from localization arguably are a significant source of gains from trade, even if they don’t seem to affect the pattern of specialization.

Excellent stuff. Great insights into how trade theory ahs evolved and very interesting examples as well.


Central Bank balance sheet expansion- both size and composition matter

December 2, 2009

Central Banks have expanded their balance sheets in this crisis. This is also called as unconventional monetary policy. However, central banks have used different ways to expand their balance sheets depending on their nature of financial markets.  so Fed has tried to help its capital markets, ECB its banks and Bank of Japan both with focus on banks.

Here is a nice paper by Shigenori Shiratsuka of IMES, Bank of Japan. He says the difference isnt as much. Central Bank balance sheet expansion means both size and composition of the balance sheet.

The distinct difference arises not because central banks have different objectives, but because they face different environments and restrictions, such as the types and origins of the shocks hitting the economy, the structure of the financial system, and institutional arrangements of the central bank. When viewing from a broad perspective, the responses of various central banks demonstrate more similarities than differences.

In theory, such unconventional monetary policy can be implemented by combining the two elements of the central bank balance sheet, size and composition. The size corresponds to expanding the balance sheet, while keeping its composition unchanged (narrowly-defined quantitative easing). The composition corresponds to changing the composition of the balance sheet, while keeping its size unchanged by replacing conventional assets with unconventional assets (narrowly-defined credit easing).

In a financial and economic crisis, both the asset and liability sides of the central bank balance sheet play an important role in countering the adverse effects stemming from the financial system. The asset side works as a substitute for private financial intermediation, for example, through the outright purchase of credit products. The liability side, especially expanded excess reserves, functions as a buffer for funding liquidity risk in the money markets. In addition, the two sides interact closely, since malfunctions in financial intermediation are closely tied to funding liquidity risk at financial institutions, resulting in the increased demand for excess reserves.

Simple way to think about central balance sheet issues.

Gennext Banking in India?

December 2, 2009

RBI Deputy Gov, KC Chakrabarty gives a talk on Gennext banking in India.

He says:


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