Paul Krugman 's International Trade Theory

Rarely, if ever, has an economics Nobel laureate been as widely known before receiving the prize as Paul Krugman. His New York Times columns have been read by millions; he has argued economic policy eloquently in a large number of popular books. Yet these pursuits had little to do with the decision of the Nobel committee. They gave this prize to honor a truly seminal figure in economic trade and geography. Mr. Krugman’s fame as a public intellectual should not lead anyone to think that they understand his contributions to economic research just because they regularly read his columns.
The Nobel Prize citation highlights two distinct but connected contributions: Mr. Krugman’s development of the “new trade theory” and his work on the “new economic geography.” International trade has a long history in economics, and for the bulk of the field’s history, patterns of trade have been explained by factor endowments and comparative advantage. Why does England export wool and Portugal export wine? The cold winters of Yorkshire produce really fluffy sheep and the banks of the Douro produce splendid grapes. Yet comparative advantage does little to explain much of modern international trade, especially not trade within industries.
Mr. Krugman published two seminal papers in 1979 and 1980 that made sense of the fact that Toyota sells cars in Germany and Mercedes-Benz sells cars in Japan. Mr. Krugman started with a variant of Edward Chamberlain’s model of monopolistic competition. In this model, every firm sells a slightly different good — an Infiniti is not exactly the same thing as a BMW. There are fixed costs of production, which means that producers get more efficient as they sell more. Finally, consumers like variety, so that even if they live in the Land of the Rising Sun, with its abundant well-made cars, they still occasionally want something a little more Teutonic.These ingredients came together and provided a framework than can match the world’s trade patterns better than the 19th-century framework of David Ricardo, or the mid-20th-century models of Eli Heckscher, Bertil Ohlin and Paul Samuelson. The fact that two out of three of those 20th-century giants are themselves Swedes should remind us of how seriously the Swedes take their trade theory, and what a big deal it is for them to admit Mr. Krugman to the pantheon.
Mr. Krugman’s trade models became the standard in the economics profession both because they fit the world a bit better and because they were masterpieces of mathematical modeling. His models’ combination of realism, elegance and tractability meant that they could provide the underpinnings for thousands of subsequent papers on trade, economic growth, political economy and especially economic geography.
Mr. Krugman’s 1991 Journal of Political Economy paper, “Increasing Returns and Economic Geography,” is the first article that provides a clear, internally consistent mathematically rigorous framework for thinking simultaneously about trade and the location of people and firms across space. It is one of only two models that I insist that Harvard’s Ph.D. students in urban economics be able to regurgitate, equation by equation.
The model begins with the same basic elements as the new trade theory: monopolistic competition, scale economics, love of variety. To these elements Mr. Krugman adds free migration of workers across space and industries. Because workers are able to move, real wages equalize across space. People in New York City may be paid more, but they give some of that back in the form of higher housing prices. The paper provides economists with a clear framework that can make sense of where we all live. Firms and workers are pulled toward the same location to reduce transportation costs of shipping goods. For example, the garment industry located in New York City, in part because of the vast trade in textiles that was already moving through the city and because of the large number of customers already living in America’s largest city.
Of course, we don’t all live in the same city. A good model of geography needs both a centripetal and a centrifugal force. In Mr. Krugman’s model, populations are pulled apart by the desire to be close to natural inputs, like land or coal mines. Cyrus McCormick moved his reaper business from Virginia to Chicago to be closer to his rural customers in the Midwest. Later models incorporated traffic congestion and other forces that limit the growth of a single large urban area. Mr. Krugman’s model proved to quite adaptable; it has received thousands of citations.
In his public role, Paul Krugman is often a polarizing figure, loved by millions but also intensely disliked by his political opponents. I still chuckle over an old New Yorker cartoon with one plutocrat saying to another that he gets some satisfaction from the fact that his vote will cancel out the vote of Paul Krugman. Within the less divided world of the academy, Mr. Krugman’s economic research has generated plenty of light, but far less heat. His papers are universally acknowledged to be immense contributions that helped to create two distinct fields. His Nobel Prize is extremely well deserved and not unexpected. I, for one, had bet on him in Harvard’s Nobel Prize winner pool.

By:- Dr.T.V.Mathew

“Nobody borrows like us... nobody spends like us... and nobody prints like us.”

Fed Reserve under leadership of Ben Bernanke is busy in devising strategies to combat one of the most severe recessions US has ever faced। BB is busy printing currency; what is the rationale behind this. Let’s figure this out.

Throughout 1990’s US had been growing at spectacular growth rates as compared to its peers. US has been the growth engine of this world economy. Consumers in the world largest economy were confident of their future incomes and this certainty and their confidence could be seen in their consumption patterns. Throughout the 1990 decade, the US households have been associated with investments exceeding savings and their consumption exceeded their incomes. Animal spirits and interest rate stability further boosted the growth. Since US had a very high income elasticity of imports and on other hand a very low income elasticity of its exports, it lead to a continued trade deficits. This made US very attractive for foreign investors, who were willing to make a quick buck in the oasis of prosperity. The slowdown in Euro region and negative growth in Japan and string of events like defaults in Mexico, Russia, South East Asian crisis made money looking for safe heaven reach US securities and the increased capital inflows affected the trade flows and dollar appreciated there by harming the relative competitiveness of US exports.

One important lesson to be learned is: be it government, household or firms...they often don’t realize they might land into deep troubles by indulging in excessive consumption. There should be some mechanisms to check their spending whenever the capital markets are too willing to lend money. Because the demand for assets to a large extent depends on the expectations of risk and return expectations. Any changes in these expectations could severely impact the demand for an asset.

USD has been the reserve currency since long and US denominated debt was always considered as risk free and investment grade. Moreover, appreciating USD gave more incentives for people to invest in US financial securities. Growing US international debt reflected the confidence the investors had in the world largest economy and its productivity and on its ability to make the right use of the money. The capital inflows will continue and US can run a trade deficit as long as it services its debt and as long as US assets deliver higher risk adjusted return compared to their counterparts. The day, the investors feel, that US is incapable of servicing its debt and there is probability of default, there would be dramatic and abrupt changes in the portfolio composition which could influence the value of USD, growth, employment, household consumption and hence savings.

The Fed’s policy of aggressive printing currency will lead to depreciation of USD in forex markets. This is expected to accentuate the BOP situation in short run but in the long run US is expected to benefit from export of services, primarily because income asymmetry faced by US is low as compared that of goods. And other reasons are liberalization of services sector throughout the world and competitive of US services industry. The income asymmetry may be explained by composition of its population, immigrants etc who continuously make unilateral payments to their relatives in home countries etc.
Moreover, Fed may be attempting to reduce the impact of high debt on the consumption patter of US households. When the interest rates rise, the PV of debt increases, which in turn requires the households to make extra provision for increased debt, which in turn reduces their consumption.

US debt is dollar denominated, so when USD depreciates compared to GBP, Yen, Yuan etc, the foreign debt reduces. This is turn will reduce the pressure on US households.

Thirdly, when the government prints currency it raises the inflationary expectations. This clearly affects the real interest expectation; any changes in real interest influence the investment demand, When the real interest are low, investment demand will increase and thereby help in stimulating the economy and provide employment.

But the most important question is who will fund this investment. In past, strong capital inflows supported the investment demand. But, with such large bail out plans, probability of default increases and this source of money will no longer exist. And considering the past trend in domestic savings, I really doubt whether households can save enough to tide over this problem.