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Week 5-6
The Domestic Sources of Foreign
Economic Policies
Foreign economic policies(FEP)
encompass:
– International trade
– International flows of investment and capital
– Immigration and emigration
– Exchange rate for national currency
2 Key domestic explanations 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
1) Policy Preferences: Trade (1)
• Heckscher-Ohlin model
– Differences in factor endowments (land, labour or
capital) create differences in comparative
advantage
– Each country tends to export those items whose
production requires intensive use of domestically
abundant factors
– Each country tends to import those items whose
production requires intensive use of domestically
scarce factors
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.
Heckscher-Ohlin model – Simplest form
1) Policy Preferences: Trade (2)
• Stolper-Samuelson theorem
– Outlining the likely effect of trade on the real incomes
of different sets of individuals within an economy.
– Assumption: factors of production are highly mobile
between different industries (shifting industry is easy)
– Trade benefits those who own the factors of
production that are relatively abundant
– Trade hurts those 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
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 benefits the factors of production that are employed
in export-oriented industries
– Trade hurts the factors of production that are employed in
import-competing industries
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)
1) Policy Preferences: Immigration (2)
• Who will oppose immigration? Why?
– “Factor-proportions” analysis
• Similar form of analysis to Heckscher-Ohlin endowmentsbased 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
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 HeckscherOhlin model)
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
• 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
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
1) Policy Preferences: Exchange Rates (2)
• Difficult to form simple class- or industrybased 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)
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
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
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
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
Complications: Information (2)
• New ideas and knowledge can have a large
impact on policy-making
• 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
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
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