IPE W2015 Final Exam ANSWER KEY

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1 IPE W2015 Final Exam ANSWER KEY Multiple choice. 2 points each. 50 points total. Choose the best response for each question and fill the bubble on your scantron. 1. If England has a lot of capital relative to labor compared to the United States, then according to the Heckscher- Ohlin model: a. England will have a comparative advantage in producing computers and the United States will have a comparative advantage in producing clothes b. The US will have a comparative advantage in producing computers and England will have a comparative advantage in producing clothes c. England will have a comparative advantage in producing both computers and clothes d. The US will have a comparative advantage in producing both computers and clothes 2. Pareto optimal means a. neither player has an incentive to change strategies unilaterally. b. no single actor can be made better off without at the same time making another actor worse off c. it is possible for at least one actor to improve its position without any other actor being made worse off d. it is possible for at least one actor to improve its position by changing strategies unilaterally e. each actor has the maximum possible payoff in the game 3. A public good is defined by two characteristics: a. Provided by government, and has a net positive effect on society b. Once the good has been provided, no- one can be prevented from enjoying its benefits, and use by one person does not diminish the ability of other people to use the good c. Non- excludable and non- profit d. Funded by all members of society, and available to all members of society e. Has positive externalities and cannot be profitably provided by private actors 4. According to Rogowski (factor model for trade- related politics), a. In an advanced- economy country with a low labor to land ratio (i.e., low population density), trade politics will be split by class cleavages b. In an advanced- economy country with a low labor to land ratio, trade politics will be split by urban- rural cleavages c. In a backward- economy country with a low labor to land ratio, trade politics will be split by class cleavages d. In a backward- economy country with a high labor to land ratio (i.e., high population density), trade politics will be split by urban- rural cleavages e. B and C 1

2 5. In a country where farm workers and textile and apparel factory workers cooperate to oppose free trade, we can assume that: a. It is likely difficult for workers to train for new industries b. It is likely difficult to re- purpose textile and apparel production machines to other purposes c. The country is likely to be capital- scarce relative to its trade partners d. The country is likely to be land- scarce relative to its trade partners e. The country is likely to be scarce in low- skilled labor relative to its trade partners 6. A country with many veto players in the political system is likely to have more a. Policy stability b. Policy volatility 7. China is labor abundant relative to the US and the US is capital abundant relative to China. According to Stolper- Samuelson, when China began to trade more intensively with the United States, this would lead to: a. Lower relative prices for labor intensive goods and higher relative prices for capital intensive goods, and therefore lower wages for labor and higher profits for capital in the US b. Lower relative prices for labor intensive goods and lower relative prices for capital intensive goods, and therefore lower wages for labor and lower profits for capital in the US c. Lower relative prices for labor intensive goods and lower relative prices for capital intensive goods, and therefore lower wages for labor and higher profits for capital in the US d. Higher relative prices for labor intensive goods and higher relative prices for capital intensive goods, and therefore lower wages for labor and higher profits for capital in the US e. Lower relative prices for labor intensive goods and higher relative prices for capital intensive goods, and therefore higher wages for labor and higher profits for capital in the US 8. China is labor abundant relative to the US and the US is capital abundant relative to China. Assume that labor is mobile between industries but capital is not. According to Ricardo- Viner, when China began to trade more intensively with the United States, this would likely lead to: (Choose the BEST response) a. Lower real wages for labor in the US. b. Lower real wages for workers in the US who spend a large share of their budget on imported goods c. Lower real wages for workers in the US who spend a large share of their budget on exported goods (i.e., goods made in the US for export) d. Higher real wages for workers in the US who spend a large share of their budget on exported goods (i.e., goods made in the US for export) e. Higher real wages for labor in the US for workers in the export- oriented industry 2

3 9. The infant industry protection argument assumes that: a. There are cases in which newly- created firms will not be efficient initially but could be efficient when they become mature b. Tariffs can help firms in new industries by providing them with a guaranteed domestic market c. Mature firms are less efficient than young firms because mature firms use outdated technologies d. Tariffs and other forms of protection can only make society worse off by preventing factors from moving out of low- return and into high- return industries e. A and B 10. The winners of Import Substituting Industrialization (ISI) policies generally include: a. Farmers because they gain access to cheaper, locally made manufactured goods b. Urban workers because they gain access to cheaper, locally made manufactured goods c. Farmers because they earn more from agricultural exports d. Factory owners in comparative disadvantaged sectors e. All of the above 11. Washington Consensus policies included: a. Democratization b. Trade and financial liberalization c. Overvalued exchange rates d. Infant industry protection e. All of the above 12. A firm s decision about whether to conduct international transactions through the market or to internalize these transactions (using FDI) depends on an interaction between a. Locational advantages and market imperfections b. Locational advantages and profit opportunities c. Natural resource opportunities and market opportunities d. Comparative advantage and transaction costs e. Labor costs and transportation costs 13. Nationalization of foreign- owned private property became widespread following World War I because: a. The Marxist- Leninist government in the Soviet Union rejected the idea of private property b. Developing countries began to broaden the notion of pubic purpose to include the state s role in the process of economic development c. Governments throughout Africa became independent, and the newly enfranchised voters demanded more control of their economies d. Persian Gulf countries expropriated oil fields in response to high oil prices and Western support for the state of Israel. e. A and B 3

4 14. Which of the following occurred during the breakdown of the Bretton Woods monetary system? a. The US ran large, consistent balance of payment deficits because of the Vietnam War b. The US ran large, consistent balance of payment deficits because of expanded welfare programs at home, including Medicaid, Medicare, and Social Security c. Germans who worried about inflation more than collapse of the exchange rate system sold large volumes of dollars to buy back German marks. d. The Nixon administration loosened monetary policy (reduced interest rates) to stimulate the US economy e. All of the above Match the exchange rate system to its definition 15. Governments establish a set price for their currencies in terms of an external standard, such as gold or another country s currency B 16. The value of one currency in terms of another is determined entirely by the activities of private actors as they purchase and sell currencies in the foreign exchange market C 17. Governments establish a set price for their currencies in terms of an external standard, but governments can change that price in certain circumstances A a. Fixed- but- adjustable exchange rate system b. Fixed exchange rate system c. Floating (or flexible) exchange rate system 18. According to Oatley, each crisis in the decade of financial crises (in Asia, Latin America, Turkey, and Russia) was distinctive in some way, yet all shared important similarities: a. Each country maintained some form of fixed exchange rate (including policies such as a crawling peg) and developed a heavy reliance on short- term foreign capital b. Each country maintained some form of floating exchange rate (including policies such as a managed float) developed a heavy reliance on short- term foreign capital c. Governments in each country borrowed heavily to finance import substitution industrialization (ISI) policies to promote economic development d. A and C e. B and C 19. Possible solutions for a government s credible commitment problem resulting from the time- inconsistency problem regarding unemployment and inflation include a. Independent central banks b. Capital controls c. Floating exchange rates d. Legislative oversight e. All of the above 4

5 20. Some causes for the real estate bubble in the United States in the 2000s likely include: a. Financial institutions used complex instruments such as mortgage backed securities and collateralized debt instruments to sell large volumes of real estate mortgages at low interest rates b. Creditor nations such as China were willing to lend money to the United States in spite of low interest rates c. The Federal Reserve was unwilling to lower interest rates d. A and B e. A, B, and C 21. In terms of Rodrik s political trilemma, the creation of the European Central Bank might be characterized as a. Sacrificing both the nation- state and democracy in order to preserve hyperglobalization 1 b. Sacrificing hyperglobalization in order to preserve democracy and the nation- state c. Sacrificing capital mobility in order to preserve fixed exchange rates d. Sacrificing floating exchange rates in order to preserve hyperglobalization e. Sacrificing hyperglobalization in order to preserve the nation- state 22. Regarding a carbon tax, Mankiw argues that a. A carbon tax would reduce economic growth without having any positive effect on the environment b. The US should not impose a carbon tax, because doing so would reduce American economic growth while China is left to continue polluting and stealing American jobs c. The US should impose a carbon tax and not worry about China, because the US would benefit from reduced carbon pollution no matter what China does d. The US should convince China to start with a small carbon tax together with the US, and then increase the tax rate over time, with a reciprocity strategy such as tit- for- tat to punish cheating, in order to facilitate cooperation e. Carbon tax is an example of a prisoner s dilemma, so an international institution such as the WTO should be empowered to act as a third party enforcer in order to achieve cooperation 23. The U.S. maintained high interest rates in the 1980s because (among other reasons): a. The Reagan administration (and Congress) cut taxes, which resulted in more domestic demand and more imports, contributing to a current account deficit for the US and the need to attract capital b. The Reagan administration (and Congress) cut taxes, which resulted in greater productivity and more exports, leading to a current account surplus for the US and the need to attract capital c. The Reagan administration (and Congress) increased military spending, which 1 NOTE TO JOSH: The exam I sent on Tuesday included and democracy but I think that makes the correct answer questionable so I deleted that clause for the rest of the students. If the student who took the exam early answered either A or D, give him credit. 5

6 increased domestic demand and imports, contributing to a current account deficit for the US and the need to attract capital d. A and C e. B and C 24. Which of the following statements are true of the relationship between macroeconomic policy and exchange rates? (Choose the BEST response) a. Floating exchange rates make it easier for a government to stimulate the economy by lowering interest rates b. Floating exchange rates make it more difficult for a government to stimulate the economy by lowering interest rates c. Fixed exchange rates make it easier for a government to stimulate the economy by raising interest rates d. Fixed exchange rates make it more difficult for a government to stimulate the economy by raising interest rates e. Exchange rate policy has no effect on the ability of governments to stimulate the economy with monetary policy 25. According to Keynes, a. Governments should cut taxes during times of unemployment in order to increase consumption, which will increase aggregate demand, which will motivate businesses to invest and create jobs to produce enough to meet demand b. Governments should reduce interest rates during times of unemployment in order to increase borrowing for items such as cars and houses, which will motivate businesses to invest and create jobs to produce enough to meet demand c. Governments should increase spending at all times in order to increase consumption, which will increase aggregate demand, which will motivate businesses to invest and increase long- term growth d. The economy will automatically and efficiently return to full employment because when unemployment increases, wages will fall, which will motivate businesses to hire more workers e. A and B 6

7 Blue Book Questions Answer 2 of the following 3 questions (25 points each): QUESTION I: Society- based Models 1. Consider the three traditional schools of IPE. Who are the principal actors in each, and what are their interests? Which of these are society- based and which are state- based models of the world? Marxist classes (ok to just say capitalist and labor), interests are to increase/maximize income for their economic class. Society based Liberal individuals (or maybe interest groups would be OK), interest is to maximize income or consumption. Soceity based Mercantilist states, interest is to accumulate gold or wealth, or to export a lot without importing. State based. GRADING (10 points maximum) +1 point EACH for the name Marxist, Liberal, and Mercantilist +1 point EACH for the IPE school descriptions. If they miss just a little, let it go, but if they miss a lot, take off a point or two. +2 extra if all the descriptions are really good. +2 for saying liberal and Marxist are society based and mercantilist is state based. 2. Explain the factor model for trade policy. Include the principal actors, economic assumptions, assumptions about factor mobility, predictions about winners and losers, and the central dimension of competition over policy. Which of the three traditional schools of IPE is closest to this model? Factor model for trade policy says that factors of production are mobile, so when there is trade, and the products using abundant factors are exported, the owners of those abundant factors will enjoy higher returns and the owners of scarce factors will receive lower returns. So relatively abundant factors win from trade and relatively scarce factors lose from trade, so the former are pro trade and the latter are protectionist. This is closest to the Marxist model because it is economic classes. GRADING (7 points maximum) +1 for saying actors are owners of factors of production (or saying capital and labor, etc.) +1 for saying the model assumes that factors are mobile (across industries) +1 for saying abundant factor owners win from free trade (or scarce factor owners win from protectionism) 7

8 +2 for getting policy preferences right (i.e., that the abundant factors favor free trade and the scarce factors favor protectionism) +1 for going into more detail on the economics, like about diminishing marginal returns or whatnot +1 for saying closest to Marxist. 3. Explain the partisan model for exchange rate and monetary policy. Include the principal actors, economic assumptions, the relative importance of monetary autonomy and exchange rate stability, predictions about winners and losers, and the central dimension(s) of competition over policy. Which of the three traditional schools of IPE is closest to this model? The Partisan model also assumes that actors are either capitalists or workers (or rightwing parties that represent capital and leftwing parties that represent workers). The economic assumptions are that fixed exchange rates are not compatible with monetary stimulus (unless capital controls are in place), because capital will flee if the interest rate drops. Also, the theory is built around the Philips curve that there is a tradeoff between inflation and unemployment because a low interest rate will cause unemployment to drop, which makes inflation rise, and high interest rates make inflation drop but unemployment rise. So because capitalists want to preserve the value of their savings, they will want to have tight monetary policy, which is compatible with/supported by fixed exchange rate, and labor wants jobs, so they will want loose monetary policy, which requires a floating exchange rate (or capital controls). So the dimensions of competition are monetary policy and exchange rate policy. It is also most like Marxist. GRADING: +1 for getting actors right +2 for properly describing Philips curve +1 for getting relationship between monetary policy and exchange rate right +1 for good explanation of the logic. +2 for getting winners and losers and/or policy preferences right +1 for saying Marxist. 8

9 QUESTION II: Exchange Rate Policy Analysis What are the pros and cons of a fixed exchange rate policy? What type of exchange rate policy would you recommend for a middle- income country such as Argentina, Turkey, or India? Some topics you might want to include: Macroeconomic trilemma Rodrik s political trilemma of the world economy Phillips curve and inflation expectations Credible commitment mechanisms Optimal currency unions Balance of payments ISI policies East Asian Miracle Financial crises ANSWER: Pros of fixed exchange rate (there may be other valid answers as well): 1. Facilitates trade (reduces transaction costs, reduces uncertainty, etc.) 2. Facilitates other forms of economic integration (e.g., FDI or cross- border work) 3. May keep inflation under control (by preventing imports from rising in cost due to changes in exchange rates) 4. May serve as a credible commitment mechanism to prevent behavior such as unsustainable deficit spending or monetary expansion 5. Prevents destabilizing behavior such as competitive devaluation Cons of fixed exchange rate (there may be others): 1. Reduces ability to use monetary stimulus (because reduced interest rate will lead to currency exiting which weakens the currency) 2. If the country is unwilling to sacrifice monetary stimulus, then the country may be forced to impose capital controls, which can undermine economic growth or lead to black market activity which leads to corruption, reduced tax revenues, etc. 3. Reduces ability of government to use fiscal policy to stimulate the economy (because fiscal deficits may signal that the government will print money to pay back debts, which would reduce the value of the currency) 4. Eliminates ability of balance of payment imbalances (such as trade deficit) to automatically re- balance through changes in exchange rates. 5. Countries who are pegged to a country with which they are not economically integrated are more likely to be harmed by fixed exchange rates for example, when 9

10 Argentina or East Asian countries were pegged to the dollar, their currency became stronger when the dollar became stronger, which made them more vulnerable to cheap imports from Brazil or Japan. 6. An overvalued fixed exchange rate (commonly used in ISI policies, and also inflicted on Argentina/East Asian countries when the US dollar got stronger) undermines the ability of the country to export, which undermines industries such as manufacturing or cash crops, which hurts jobs and economic growth and also leads to foreign currency shortages which can lead to debt crises/financial crises 7. An undervalued fixed exchange rate leads to current account surplus (or trade surplus) which leads to accumulation of foreign currency which then leads to capital account deficit (or can just say balance of payments imbalance) as the exporting country invests in/buys bonds from/deposits in the importing country, which can then lead to financial crises in the importing country, which undermines the ability of the importing country to continue buying from the exporting country. Recommendation: There is no single right answer, but the answer should address be supported with reasoning that draws on the pros and cons above. For example, 1. Students might recommend a floating exchange rate, so that the country is able to use monetary policy (and fiscal policy) to stimulate their economies when they fall into recession, and so that trade deficits will not be able to endure. However, the floating exchange rate has disadvantages for example, if the currency gets weak then that could lead to inflation, or if the currency fluctuates that might undermine trade. A sophisticated answer might suggest having some capital controls in place, or a managed float through foreign currency transactions in order to avoid some of the dangers of a floating currency. 2. Students might recommend a fixed exchange rate in order to reduce transactions costs and uncertainty, but they should include some additional information to address the problems. For example, they might recommend that the currency be fixed with major trading partners, or they might recommend that the currency be fixed at a competitive or even undervalued exchange rate to facilitate exports. 3. Students might recommend a hybrid such as a managed float or an adjustable fixed exchange rate. GRADING (25 points maximum): Up to 10 points for a very strong list of pros with explanations. One way to get 10 points could be at least two pros mentioned, with very good explanations. Another way to get 10 points might be several (perhaps 4 or more) pros mentioned with adequate explanations. Just one pro with a very good explanation would be partial credit, perhaps 5 points. A list of pros with no explanation whatsoever would be 5 points. Illustrative examples would be worth additional points. Up to 10 points for a very strong list of cons with explanations. Up to 5 points for a recommendation that is supported with relevant arguments. 10

11 If the answer falls short of 25 points but the student also mentions some political points that aren t listed above, or mentions that any exchange rate policy is technically possible, the challenge is political, that is worth additional points. If the answer falls short of 25 points but the student also draws a diagram and correctly explains the Phillips curve and/or the trilemma, that is worth additional points. Subtract up to 5 points for details that are blatantly wrong. 11

12 QUESTION III: IPE in the News All eyes are on the Federal Reserve this week as it convenes for its latest two- day policy meeting. The central bank is under the microscope lately. Since late 2008, the Fed has held short- term interest rates at zero in an effort to stimulate economic growth. But it is expected to begin raising them in the coming months. The world has been looking for hints of when that will happen. While all that's going on, something else historic is happening: the Euro is dropping and the dollar is appreciating... so much so that the two may soon be equal in value. That has pluses and minuses: it's great news if you're an American who wants to buy Italian wine or a hotel room in Paris. It's bad news for US companies trying to sell their goods abroad. But it's also a good reason for the Fed to be extra- patient about raising interest rates. A rising dollar will limit inflationary pressures, giving the Fed the breathing room it needs to focus on boosting economic growth. a. What is the Federal Reserve s dual mandate, and what is its main tool to deliver on its mandate? ANSWER: The Federal Reserve s dual mandate is to keep both unemployment and inflation low. Its main tool is interest rates (or buying and selling bonds to achieve a particular interest rate). Reducing interest rates can reduce unemployment but increase inflation; raising interest rates can reduce inflation but increase unemployment. GRADING (3 points): +1 for saying inflation +1 for saying unemployment +1 for saying interest rates b. Explain why low interest rates would stimulate economic growth. ANSWER: I ll take either of the following answers. (1) lower interest rates encourages businesses to borrow to invest which leads to increased production, (2) lower interest rates encourages consumers to buy houses or cars which encourages businesses to produce to meet that demand, (3) lower interest rates leads to more money in the system which leads to inflation which lowers real wages (nominal wage minus inflation) which leads lower employment costs which encourages employers to hire more workers and produce more. GRADING (4 points): Full credit for either explaining one of those answers well, or explaining 2 or more of those answers somewhat poorly Partial credit for a weak or slightly incorrect answer c. Explain why the Fed would want to raise interest rates in a few months. 12

13 ANSWER: The Fed may want to raise interest rates if inflation begins to rise. Increasing interest rates would increase the cost of borrowing which would deter businesses from borrowing to invest and/or consumers from borrowing to buy houses or cars GRADING (3 points) +2 points for saying inflation +1 points for explanation d. What are some possible explanations for the dollar s appreciation against the Euro? Use a diagram of the market for dollars to explain your reasoning. ANSWER: The answer should include either an increase in demand for dollars (which is equivalent to an increase in supply of Euros) or a decrease in supply of dollars (which is equivalent to a decrease in demand for Euros). For full credit, the answer should be more specific than that. For example: 1. Perhaps the ECB has reduced interest rates in Europe. This increases demand for dollars (or an increase in supply of Euros) because fewer people want to continue holding Euros, and so they are exchanging Euros for dollars so they can deposit their money in the US instead. OR it might decrease supply of dollars (or decrease demand for Euros) because fewer people with dollars want to trade those dollars for Euros. 2. Perhaps Greece is in danger of defaulting, or something similar. This would have the same effect as above. 3. Perhaps Europeans are buying more goods from America. This means more Europeans need to sell their Euros (increase in supply of Euros) to buy dollars (increase in demand for dollars), which increases the value of the dollar relative to the Euro. 4. Perhaps Americans are buying fewer goods from Europe. This means fewer Americans need to sell their dollars (decrease in supply of dollars) to buy Euros (decrease in demand for Euros), which increases the value of the dollar relative to the Euro. GRADING: (7 points maximum) 2 points for saying (or showing) that the demand for dollars increases OR the demand for Euros falls OR the supply of dollars falls OR the supply of Euros increases. 2 points for correctly drawing the diagram (give full credit for correctly drawing a market for Euros diagram) 2 point for either explaining the logic correctly or showing the logic correctly with the diagram 1 point for providing a good detailed explanation such as the ECB reduced interest rates e. Explain why the dollar appreciating against the Euro is good news for some Americans and bad news for others. ANSWER: The dollar appreciating against the Euro is good news for Americans who want to buy European imports OR for Americans who want to travel in Europe OR for Americans who want to buy European real estate or European businesses. The dollar appreciating is bad news 13

14 for Americans who are exporting to Europe (business owners or employees) OR for Americans who cater to European tourists in America, etc. GRADING (4 points maximum) 2 points for Americans who benefit 2 points for Americans who lose (if they do one but not the other but give a very good explanation, that can be worth up to 3 or 4 points total credit) f. Explain why the rising dollar gives the Fed breathing room. What does the author mean by breathing room and why does the rising dollar provide it? ANSWER: The rising dollar makes imports cheaper, which reduces inflation, which means that the Fed has less need to raise interest rates to reduce inflation. The breathing room means the Fed can continue doing monetary stimulus to reduce unemployment without the consequence of inflation rising. GRADING (4 points): +2 for making the point that the rising dollar will reduce inflation through cheaper imports +2 for making the connection that lower inflation (from cheap imports) reduces the need for the Fed to raise interest rates, even when unemployment is low. 14