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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