Week 6

1. Week 6 The Domestic Sources of Foreign Economic Policies

2. Foreign economic policies(FEP) encompass: • International trade • International flows of investment and capital • Immigration and emigration • Exchange rate for national currency

3. 2 Keydomesticexplanations of different choices/decisions in FEPs 1) The policy preferences (Trade, Immigration, Foreign Investment, Exchange Rates) of different groups in the domestic economy • Requires economic analysis • Basic assumption: individuals and groups are concerned about how different policy choices affect their incomes 2) How domestic political institutions(Types of Political Systems, Legislatures and Policy-making Rules, Bureaucratic Agencies)determine the way these preferences are aggregated or converted into actual government decisions • Requires political analysis

4. 1) Policy Preferences: Trade (1) • Heckscher-Ohlin model • Differences in factor endowments (land, labourorcapital) create differences in comparative advantage • Each country tends to exportthose items whose production requires intensive use of domestically abundantfactors • Each country tends to importthose items whose production requires intensive use of domestically scarcefactors

5. Absolute Advantage vs. Comparative Advantage – Specialization Absolute Advantage: One nation can produce more output with the same resources as the others. Comparative Advantage: One nation produces a good of a lower opportunity cost than the other.

8. Heckscher-Ohlin model – Simplest form

11. 1) Policy Preferences: Trade (2) • Stolper-Samuelson theorem • Outliningthelikelyeffect of trade on therealincomes of differentsets of individualswithin an economy. • Assumption: factors of production are highly mobile between different industries (shiftingindustry is easy) • Trade benefitsthose who own the factors of production that are relatively abundant • Trade hurtsthose who own the factors of production that are relatively scarce • Trade creates winners and losers within each country: • Winners would support greater trade openness • Losers would be against greater trade openness

13. 1) Policy Preferences: Trade (3) • Specific factors model (now the most commonly accepted) • Accounts for coalitions between labour and capital in the same industry (interests assumed to be opposed in Stolper-Samuelson) • Relaxes the Stolper-Samuelson assumption that factors of production are highly mobile between different industries • Different types of factors of production have very limited or specific use • Trade benefitsthe factors of production that are employed in export-oriented industries • Trade hurtsthe factors of production that are employed in import-competing industries

15. To be continuedafterthe break

16. 1) Policy Preferences: Immigration (1) • In principle, and at the aggregate level: • Freedom of movement for labour will lead to increases of total output of goods and services (at global and national levels) • Labour movement should respond to price signals to improve economic efficiency • International movement of labour (and other factors of production) is a substitute for movement of goods (within Heckshcer-Ohlin model)

17. 1) Policy Preferences: Immigration (2) • Who will oppose immigration? Why? • “Factor-proportions” analysis • Similar form of analysis to Heckscher-Ohlin endowments-based theory • Additional distinction is made between types of labour: e.g. high-skilled vs. low-skilled • Immigration harms local workers with similar skill levels to those of the arriving workers • Owners of land and capital are likely to be the strongest supporters of more immigration • Non-economic factors (culture, identity) are also very important

19. 1) Policy Preferences: Investment (1) • Portfolio investment: purchases of company shares and other forms of securities, including government bonds • Foreign Direct Investment (FDI): purchase of assets by foreigners that lead to ownership control of a firm • In general, it is reasonable to expect large flows of capital from industrial nations to the developing world (in line with Heckscher-Ohlin model)

20. 1) Policy Preferences: Investment (2) • Who will oppose inward investment? Why? • “Factor-proportions” analysis • Inflows of foreign capital will lower real returns for local owners of capital • Inflows of foreign capital will increase real earnings of land and labour by increasing demand of these factors • NOTE: bulk of FDI in modern world economy occur between industrial economies alone • Firms gain advantages in “jumping borders” and trade barriers (e.g. access to foreign markets) • FDI allows firms to internalize transactions

22. 1) Policy Preferences: Exchange Rates (1) • Policy choices: • Allow the value of the currency to fluctuate freely • Fix the value of the currency • There is no consensus among economists on exchange rate policy • There is a trade-off between monetary policy and exchange rate policy • EITHER stable exchange rates but no control of monetary policy • OR fluctuating exchange rates and independent monetary policy

23. 1) Policy Preferences: Exchange Rates (2) • Difficult to form simple class- or industry-based analysis of policy preferences • Individual interests vary according to a range of considerations such as: • Ownership of factor of production (labour or capital) • Specificity of factors of production (fixed or mobile) • Destination of the output of production (export or domestic market) • Reliance on foreign markets (net purchases or net investments)

24. 2)Institutions: Political Systems • Autocratic regimes may support either trade liberalization or trade protection • In democracies, the balance of policy preferences can be affected by: • The extension of the electoral franchise • The voting system adopted • The cost of political action and lobbying • The design of electoral districts

27. 2) Institutions: Legislatures & Rules • Legislative rules determine the way policies are proposed, considered, amended and voted upon • Lobby groups’ ability to access lawmakers increases chances of protectionism • An institutional ability to link domestic tariff reductions with reciprocal reductions abroad can facilitate trade liberalization

31. 2) Institutions: Bureaucratic Agencies • How bureaucratic agencies implement or administer foreign economic policies can have important effects • The danger of “bureaucratic capture” by partisan groups

35. Complications: Information (1) • Standard political economy approach assumes that individuals know • what they want • what others want • what types of policies will have what effects • More recent research has emphasized • Uncertainty • Asymmetry of information among actors • Changes in knowledge due to learning and the impact of new ideas

38. Complications: Information (2) • New ideas and knowledge can have a large impact on policy-making • However, ideas can also be a simple reflection of vested interests • Many individuals have incomplete information about foreign economic policies and are susceptible to issue-framing or manipulation • Governments may choose to “tie their hands” in order to demonstrate credible commitment to certain policies

43. Complications: Issue Linkages • The effects of different policy instruments depend on how other policies are set • Linkages can be made with both economic and non-economic policies (e.g. national security, environmental policies, human rights issues) • Interesting coalitions may emerge • Issues may be “hijacked” by powerful groups • Non-economic goals may trump economic goals or outcomes

48. Complications: Int’l Bargaining • Putnam’s (1988) “two-level game” • Governments engaged in international economic negotiations are involved in two different political games simultaneously • International level: relative size and strength can be important • Domestic level: preferences of domestic groups and legislative processes are important