The Essay On Keynesian Theory And Comparative Advantage In International Trade.

1) Explain the Keynesian theory of (private) investment expenditure. What are the implications for the stability of investment and hence GDP growth? How realistic is this explanation of investment expenditure?

2) International trade is determined on the basis of comparative advantage. Discuss. Does free trade benefit all countries

Overview of Keynesian Theory of Investment

Keynes gave “The General Theory of Employment, Interest and Money” explaining the dynamic between the three factors: employment, interest rates and money. In these, Keynes explained how investment gets a boost when the interest rates are low. Low interest rates, induce consumers to spend more (in turn, boosting investment) and producers to invest more. Keynes also, gave an understanding of the multiplier effect which causes the economy to grow further, once the economy achieves an expansionary trajectory.(Samuelson & Nordhaus, 2010) A general depiction of this model is given below:

Illustration 2 : The Investment Multiplier Model. Source: (Samuelson & Nordhaus, 2010)

In Panel A, as the Reserve Bank of Australia reduces the cash rate, for example from 2% to 1.5 %. This leads to an increase in money supply from S_A to S_B within the economy. Money supply increases because it is a lot more  profitable for producers and consumers to hold in hand cash balances rather than make bank deposits.

In Panel B, the impact of  reduction in interest rate is depicted, given that lower interest rates would be an incentive for producers to borrow money, as credit would be easy to come by. Assuming investment was at an index of 100 and would now shift to, an index of 200. This investment would, to some extent, result in an expansion of production capacity.

In Panel C, as production  capacity increases, the general level of output and employment may increase too. This is economic expansion. (Samuelson & Nordhaus, 2010)

According to Keynes, the increase of money supply does not have just a direct effect, rather an “ accelerating effect” i.e. investment begets higher output which in turn leads to greater money supply leading, again to more investment. Hence, there is a multiplier effect. (Samuelson & Nordhaus, 2010)

This theory has its shortcomings as it only takes a monetary view of the economy and does not address structural issues or “real” economy.

The Theory of Comparative advantage was given by David Ricardo and is also known as “Ricardian Theory of Comparative Advantage”. The Theory suggests that every country should export that product in the production of which, it has a comparative advantage in.(K?l?, 2002). According to the Theory, even if a country has a comparative advantage, it should still get involved in Free Trade as by doing so, it can focus on production of the product that it is best suited to produce.

According to Ricardian Theory postulates, (K?l?, 2002)

Total Output= Marginal Productivity of Labour X Total Number of workers

For example, the two countries Australia and New Zealand, country that produce both grapes and corn. The price for both goods are given in the table 1. The Marginal Productivity of Labour, or the number of units (kilos) of product produced per unit of labour per hour,  is given in Table 2

• Each country produces only the two goods: Corn and Grapes
• The labour force (number of labourers) in both countries is the same
• Both countries are in autarky(i.e. Economically self sufficient)
• There is a no other form of international trade
• There is only one factor of production i.e. labour

(Feenstra, 2015)

Table 1: Marginal Productivity in Australia and New Zealand

Each of these countries will export the good that it has “comparative advantage” in. In this example, comparative advantage can be gained only from the marginal productivity. Hence, the price of both products in both the countries (hypothetically) is:

Table 1 Price of Corn and Grapes in both countries (AUD per Kilo)

In this example, it also follows, that the price of a product will be lower in the country for the product that which it has higher marginal productivity in. Hence, it should export that product.

Australia is better off with trade, even when the Marginal Productivity of Labour of Australia for both products is higher. According to the Ricardian theory, even when a country gets better terms of trade in both the products it produces, it must specialize in the production of the product that it has an advantage in (in this case, the product that it has a higher Marginal Productivity of Labour in). In doing so, each country shall be able to maximize the efficiency of allocation of factors of production.(Feenstra,2015) Hence, both countries shall profit from indulging in Free Trade.

References:

Feenstra, R. C. (2015). Advanced International Trade Theory and Evidence: Second Edition. Princeton, New Jersey: Princeton University Press.

Kili¸c, R. (2002). University of Michigan. Retrieved August 23, 2018, from Absolute and Comparative Advantage: Ricardian Model: www.msu.edu

Samuelson, P., & Nordhaus, W. (2004). Economics: Seventeenth edition. New Delhi: Tata McGraw Hill.