INR 2002 Exam 2

Free trade is mutually beneficial. So, why do barriers to trade exist?

a.     Benefits and costs are unevenly distributed and those who experience the cost tend to be a smaller number so they can solve the collective action problem better

b.     Mercantilist beliefs – exports are more valuable than imports, motivating a lot of trade restrictions

We discussed four ways that trade increases wealth. State any two of those four. 

a.     Opens new markets

b.     Increases efficiency

c.     Leads to less expensive products

d.     Leads to better (higher quality) products

What two ideas did Adam Smith highlight for how trade increases productivity, which increases wealth?

a.     Specialization

b.     Division of labor

In the context of international trade, what is absolute advantage? 

a.     the ability of a party (a country, firm, or individual) to produce a greater quantity of a good or service than competitors using the same amount of resources, or to produce the same quantity at a lower absolute cost

b.     an actor can produce something better, or cheaper than other actors**

In the context of international trade, what is comparative advantage? Why is comparative advantage important? When implemented, what is the effect of comparative advantage on production and country-level wealth? 

a.     The idea that countries should specialize in their economic production based on the opportunity costs of producing various goods

b.     Comparative advantage is important because it increases efficiency and it leads to increased production and an increase in country-level wealth

c.     Leads to better growth, profit, and money

What is opportunity cost? 

a.     The value of the next best thing given up

b.     What you give up when you pursue one option over another**

What are the three factors of production that we discussed in class? 

a.     Land

b.     Labor

c.     Capital

What are the two types of human capital discussed in class? 

a.     Human (Education + Health)

b.     Financial

What does the Heckscher-Ohlin model tell us about who exports what and who imports what? In other words, explain the Heckscher-Ohlin model. 

a.     Labor abundant countries export labor intensive goods, and import capital intensive goods

b.     Capital abundant countries export capital intensive goods and import labor intensive goods

c.     Relative endowments determine comparative advantage

Why do countries restrict trade? In other words, what is the primary political problem with trade? 

a.     Some people lose from trade; benefits of trade are unevenly distributed

b.     Domestic producers lobby for protection, and due to their smaller size and the collective action problem, producers have an advantage over consumers in getting policy they want passed

c.     Protectionism increases costs; producers typically pass on most costs to consumers

d.     **to cater to domestic interests and/or mercantilist beliefs

What are mercantilist trade preferences? 

a.     Exports are strongly preferred to imports

Trade barriers redistribute income from who to whom? 

a.     From consumers and foreign producers to domestic producers

What is protectionism? 

a.     The use of specific measures to shield domestic producers from imports

What are two types of trade barriers? 

a.     Tariffs

b.     Non-tariff barriers

What are three types of non-tariff barriers? 

a.     Quota

b.     Subsidies

c.     Prohibitions

Which type of trade barrier, tariffs or non-tariff barriers, has increased the most over the last couple of decades?

a.     Non-tariff barriers 

What does the Stolper-Samuelson theory tell us about individual preferences on trade policy? Who favors free trade? Who favors protectionism? Why? 

a.     Preferences are based on general factors of production

b.     Trade benefits/is favored by those in the abundant factor of production, because those are the type of goods that we export

c.     Those in the scarce factor of production favor protectionism, because they do not want us to import the goods they produce, increasing the level of competition they face from foreign producers of the same good

What does the Ricardo-Viner theory tell us about individual preferences on trade policy? Who favors free trade? Who favors protectionism? Why?  

a.     Preferences are based on specific industries or firms

b.     Favor free trade if your industry is internationally competitive

c.     You favor protectionism if your industry is not internationally competitive

Why is the cost of sugar higher in the United States than in most other countries? Which of the major social interaction (i.e. cooperation) challenges did we highlight as central to explaining the increased cost of sugar? Specify the actor facing the challenge/problem.

a.     Cost of sugar is higher because domestic sugar producers lobbied for protectionism of the sugar industry.

b.     Collective action problem is central to explaining increased cost of sugar. Sugar producers have a small group size and can effectively lobby the government. While domestic consumers now must pay 2c/day extra for sugar, the difference isn’t noticeable, and consumers group size is too large for there to be effective lobbying against this. 

c.     **Government subsidies have made sugar less competitive and price of sugar higher to cater to domestic groups

Which type of political institutions (democratic or non-democratic) will typically be more supportive of free trade? Why? 

a.     Democracies tend to be more supportive of free trade because they have greater desire for freedom in general, stemming from ideological differences between them and non-democracies.

b.     Also, because of selectorate theory – democratic leaders need a large number of people to stay in office; trade benefits the aggregate

What is the embedded liberal compromise? 

a.     Compensation from winners to losers from trade

Which social interaction (i.e. cooperation) challenge did we use to explain how many countries approach the making of international trade policy? What is the primary assumption motivating this social interaction challenge? (Hint: what sort of trade preferences do the actors have and why?)

a.     Collaboration problem – we used the example of the prisoner’s dilemma

b.     Key assumption is mercantilist trade preferences – that is, that exports are strongly preferred to imports; the positive trade balance is what gives the Prisoner’s Dilemma

What principles did GATT (General Agreement on Tariffs and Trade) use to lower trade barriers? 

a.     Norms of reciprocity and national safeguards  – tariff rates are the same for all (with a few exceptions for regional trade agreements and less developed countries)

What is most favored nation status? 

a.     Universalizing of your lowest tariff rates for whichever countries you have most favored nation relationship status with

What is the primary difference between the GATT and the World Trade Organization (WTO)? 

a.     There are more countries in the WTO

b.     **WTO has greater enforcement capability – if a country brings a trade complaint and it is found to be true, fines can be imposed on the country

In classical economic theory, do all states have a comparative advantage in something or do only some states have comparative advantages? 

a.     All states have a comparative advantage in something

Is comparative advantage about producing something cheaper than others? Explain.

a.      No, it is about doing what gives you the most profit

1.     Imagine a country abundant in capital and scarce in unskilled labor. Apply the Stolper-Samuelson theory to answer the following questions. 

a.     In this country, which economic group is likely to favor protectionism?

b.     In this country, which economic group is likely to favor more free trade oriented policies? 

i.      The scarce factor is likely to favor protectionism – so unskilled labor

ii.      The abundant factor – so capital

If countries want investment so greatly, why are relations between foreign investors and countries so hostile and politically controversial? 

a.     They disagree about the terms of the investments – both over the rate, and what needs to be done in exchange for the investment (austerity measures)

What started the 2008 financial crisis in Europe?

a.     Started with a credit crunch in US housing markets; US housing bubble bursts

b.     Housing bubbles burst in Ireland and Spain

c.      Portugal and Greece need bailouts

The European Union (EU) and the International Monetary Fund (IMF) agreed to bailout Greece in 2008. What did they ask for in return for the loans? Explain. 

a.     They required Greece to undergo political reforms

b.     Cut expenditures (welfare payments) and raise taxes

c.      This would allow them to pay the EU back

What are austerity measures? 

a.     Terms of investment that investors require of borrowers

b.     Usually involve more taxes and less spending (welfare)

What are the two primary types of foreign investment? 

a.     Portfolio Investment

b.     Foreign Direct Investment

How do portfolio investments differ from foreign direct investments (FDI)?  Describe or give an example to illustrate portfolio investment and foreign direct investment.

a.     For portfolio investments, the investor has no role in management. It can include stocks, loans, and bonds. Typically is sovereign lending (an individual purchasing bonds from government

b.     Foreign direct investments can also be thought of as multinational corporations. For these, investors acquire real assets (facilities) in a foreign country

Since about 2010, which of the following constitute the largest portion of foreign investment: equity investments, bonds and loans, or foreign direct investment? (See Figure 8.1) 

a.     Foreign Direct Investment

Which region had the most foreign direct investment in 2015 (and 2010): Africa, Asia, Europe, Latin America, North America? (See Figure 8.2)

a.     Europe

Is FDI more common between two wealthy, developed countries or one wealthy and one less developed country? Explain why. 

a.     Two wealthy, developed countries because wealthy countries have more stable economies, and the investments there are more secure

Why do investors invest in foreign countries? Explain how it typically works. 

a.     To make money

b.     Investors invest abroad to earn higher rates of return on their capital; capital is scarce in poor countries, so there are higher interest rates

c.      **higher interest rates offered by other countries; cheaper labor, new markets

Why do firms borrow from foreign investors? 

a.     Borrowers borrow capital to increase productivity of other factors of production (especially labor)

What is concessional finance and where does it typically come from? 

a.     A loan given by a bank with below-market interest rates

b.     Usually comes from the World Bank and goes to less developed countries to support infrastructure projects

What are three sources of conflict between investors and borrowers? 

a.     Terms of the investment – conditionality

b.     Variable rate loans

c.      Obsolescing bargain (a credible commitment problem)

When a government borrows money from foreign investors, who often benefits within the country? If that country has difficulty paying back the loans, who often pays the most within the borrowing country? 

a.     Benefit: those politically connected to the government, or people reasonably well off

b.     Paying the most: regular citizens

What is moral hazard and how does it apply to international finance? 

a.     Moral hazard is that idea that an actor engages in riskier actions when they do not have to pay the full cost for their actions

b.     It applies to international finance because when banks face insolvency, they choose to make risky loans because if the loans go bust, they will be bailed out

What is a typical solution for a moral hazard problem? 

a.     The Federal Deposit Insurance Corporation – guarantees your bank investment up to some amount if a bank collapses; meant to prevent a run on the bank

b.     **Institutions (more broader term)

What are the Bretton Woods twins? 

a.     World Bank and International Monetary Fund

What does the international monetary fund (IMF) do? 

a.     Manage the international monetary system and attempt to prevent disastrous failures like the Great Depression

b.     They make loans, negotiate new terms with lenders, and certify compliance

Why do IMF borrowers sometimes object to the lenders’ demands? 

a.     Borrowers don’t want to impose the austerity conditions that are demanded on them because it makes them politically unpopular

What are the three primary types of foreign direct investment (FDI)? Briefly describe each. 

a.     Greenfield

b.     Mergers & Acquisitions

c.      Joint ventures

Why do firms/corporations sometimes pursue FDI? (You have to say more than “to make money.”) Why do host countries seek FDI? 

a.     Reasons for pursuing FDI: market access, to acquire natural resources, to minimize factor costs (usually labor), lower taxes, seeking lower regulatory environment, outsourcing

b.     Reasons for seeking FDI: less risky than loans, create jobs, spillover effect

How is foreign direct investment (FDI) regulated? 

a.     Unlike trade, FDI is not deeply regulated at the international level

b.     Instead, there are Bilateral Investment Treaties that operate on a country-to-country basis (unique individual agreements for the rules on FDI, and they can vary from one to another)

An obsolescing bargain is similar to what type of problem that we discussed in Chapter 2, Unit 1, and on several other occasions this semester?  

a.     A credible commitment problem – the investment becomes less valuable overtime, which makes it harder to get a loan to begin with

What does the Heckscher-Ohlin theorem tell us about immigration? 

a.     Workers move from labor abundant to labor scarce countries

What is a currency crisis? 

a.     A sudden collapse in the value of the currency

If no one wants a currency crisis, why do they sometimes occur?

a.     Sudden collapse because a typically less developed country’s currency is pegged to some other benchmark, and that country is running large deficits for a long period of time. Because of those deficits, investors believe the country cannot maintain the value of the peg, and will have to depreciate the value of the peg. The government doesn’t want to, but investors don’t believe this. Eventually, there is enough investor speculative attack, that the currency value collapses

What are three major purposes of money? 

a.     A unit of account

b.     A store of value

c.      A medium of exchange

What three general factors affect the stability and value of money? Briefly explain each.

a.     Domestic interests and policies (specifically interest rates) – domestic policies that involve a balanced budget and stable interest rates

b.     The country’s role in the global economy – smooth, well-functioning trade regime (sometime out of a country’s control)

c.      The country’s interaction with international institutions – agreeing to the rules for the loans, and honoring those rules

What is the exchange rate? 

a.     The price of a national currency relative to other national currencies

How can a state decrease the value of its currency? 

a.     Issue more money, flood the market, to make each unit have less value

b.     Lower interest rates

How can a state raise the value of its currency? 

Increase interest rates to decrease money supply

Which groups in a country tend to favor an undervalued currency? 

a.     International traders (businesses exporting goods)

Which groups in a country tend to favor an overvalued currency? 

a.     Tourists

b.     Domestic consumers

What are the pros and cons of a fixed exchange rate regime? 

a.     Pros: stability, good for travelers and traders

b.     Cons: Reduces government flexibility

What are the pros and cons of a floating exchange rate regime?

a.     Pros: more government autonomy

b.     Cons: less stability/certainty in the rate

Which groups in a country tend to favor a fixed exchange rate regime? 

a.     Domestic exporters/international businesses because it makes trade much easier

b.     Maybe tourists

Which groups in a country tend to favor a floating exchange rate regime? 

a.     Domestic consumers because they are not really buying much internationally

What does a “strong” dollar mean for U.S. trade? 

A phrase used to indicate your countries currency is overvalued

means imported goods are cheaper for US consumers, but exports are more expensive and less competitive internationally

Why are most Central Banks quasi-independent? What type of problem, social interaction challenge, are they trying to address? Explain. 

a.     They are independent because politicians do not have an incentive to not “monkey around” with interest rates

b.     They are quasi-independent to address the credible commitment problem

i        They help keep inflation and unemployment low

to separate monetary policy from short-term political pressures, ensuring long-term economic stability and low inflation

When was the gold standard the dominant international monetary regime? 

a.     1870-1914

In what way is the gold standard good for international trade?

a.     World essentially had one currency. A lot of stability, so businesses or investors did not have to worry about drastic changes to exchange rate  

If William Jennings Bryan got his wish and the U.S. adopted a bimetallic standard (gold and silver), what would have happened to the value of the dollar? (B) Would exports or imports likely increase? (C) Which group of economic interests supported this policy? Which economic interests opposed it? 

a.     Value of the dollar would have decreased, leading to inflation

b.     Exports would likely increase, because goods would’ve become cheaper for people in other countries to buy

c.      Farmers and debtors would have supported this (Bryan’s base); bankers, lenders, and industrialists would have opposed it (McKinley’s base)

How does the Wizard of Oz connect to international monetary politics? Who or what do the following represent, from a monetary policy perspective? 

a.       Oz = An ounce of gold

b.      Yellow brick road= The Gold Standard

c.       Scarecrow= farmers; Bryan’s constituents

d.      Tin man = NE Industrialists

e.       Lion = William Jennings Bryan

f.        Dorothy = naïve American

g.       Wizard = McKinley

h.      What does Toto do at the end of the story? Reveals the Wizard (McKinley) is a scam

i.        In the book what color are Dorothy’s slippers?  Silver

When did the Bretton Woods monetary regime start and end, approximately? How did it function? What was the value of the U.S. dollar? Why did it end? 

a.     Started after WWII (late 40s), ended in 1971

b.     How it worked: The US dollar was fixed (35$/ounce of gold); other countries could adjust the value of their currency

c.      It ended because the Vietnam War and Johnson’s Great Society program led to significant deficits and lots of gold leaving the US. So Nixon made the choice to go off the Gold Standard thinking it would help him politically

What is the name for the current international monetary regime? 

a.     Managed float

Sometimes monetary policy is viewed as being like a Prisoner’s Dilemma. What is the key assumption that motivates this perspective? 

a.     Mercantilist assumption (preference for a weaker currency) – exports are preferred to imports

What common explanation for economic development is not supported by the post-World War II difference in economic growth of North and South Korea? What explanation for the difference in economic growth of these two countries did we give in class? 

• Common explanation not supported: Culture and/or geography influence economic growth

• In reality, institutions are the reasons for economic growth. This includes things like property rights and free enterprise in South Korea created an incentive for greater production. Political choices drive economic institutions

What two common explanations for economic development are not supported by the postindependence difference in economic growth of Zambia and Botswana? What explanation for the difference in economic growth of these two countries did we give in class?

• Common explanations not supported: culture, colonialism, and geography

• In reality, different political institutions in each country led to different protection of property rights

  • Botswana promoted human capital better than Zambia

  • Zambia had one party dictatorship rule whereas Botswana has been mostly democratic

The triumph of narrow interests often leads to poor public policies. What core social interaction problem often results in the triumph of narrow interests? 

Collective Action Problem

What is an encompassing coalition? Historically, what is a common way to achieve an encompassing coalition? 

• alliances that concern enough of society to be concerned about broad social welfare;a large winning coalition/political coalition that involves many interests in society

• You can achieve an encompassing coalition through representative political institutions, national unification, and the existence of an external threat

• creators/colonizers of countries are de-incentivized to put in extractive institutions. An external threat could unify the country, helping to create this

North and Latin/South America were both colonized. Why have their economic paths differed, according to Acemoglu, Johnson, and Robinson? Explain. 

• Primarily the result of institutional and political differences

• North America introduced inclusive institutions (general assemblies, etc.)

• Spanish conquistadors introduced extractive institutions ( took over hierarchies and enslaved people)

• Bad institutions make it hard to foster economic growth; disease also makes this difficult

Tell me three things you learned about foreign aid in class. 

• Foreign aid is unlikely to actually significantly affect economic development

• Foreign aid typically makes governments dependent on the lender instead of the public, so there is less incentive to provide good domestic policies

• Poor countries usually with limited democracy need aid the most, and they are most likely to abuse the aid

• aid groups and governments have gotten smarter, and there have been a lot more strings attached to aid