Final Exam PS 124A: International Political Economy

Wednesday Version

Choose four questions to answer. Each is worth 25 points.

Trade
In the North Pole, there live 660 elves. Every North Pole Elf is the same. The elves make toys and cookies. To survive, they eat cookies and play with toys. Five elves, working together, can make one cookie per day. Fifteen elves, working together, can make one toy per day. What is the production possibility frontier, per day, of the 660 elves if they are isolated in the North Pole? Draw the PPF, with Toys on the x-axis and Cookies on the y-axis. What is the price of Toys in terms of Cookies? Show all of your work. (6 points)
In a secluded forest, there live 360 elves. Every Forest Elf is the same. These elves also make and live on toys and cookies. But for Forest Elves, two elves can work together to make one cookie per day, and twelve elves can work together to make one toy per day. What is the production possibility frontier, per day, of the 360 Forest Elves? Draw the PPF, with Toys on the x-axis and Cookies on the y-axis. What is the price of Toys in terms of Cookies? Show all of your work. (6 points)
One day, the North Pole elves come upon a herd of flying reindeer, one with a glowing red nose. The flying reindeer enable the North Pole Elves to begin trade with the Forest Elves. Assume that the international price of Toys in terms of Cookies is 1 Toy per 6 Cookies. What is the new production possibility frontier for the North Pole? What is the new production possibility frontier for the Forest? What do you predict will be the direction of trade? Who are the winners and who are losers from trade? Explain your logic.(7 points)
Now assume that, in each of these locales, not all elves are the same. Assume that, before the discovery of the flying reindeer, some elves in both the North Pole and the Forest had invested in Cookie-making skills, and learning to make Toys will take 100 years. Similarly, some elves in both the North Pole and the Forest had invested in Toy-making skills, and learning to make Cookies will take 100 years. How does this change who the winners and losers are, if at all? Explain your logic. (6 points)

Society-based models

Ali is the wealthy owner and president of a successful textile firm, based in Guatemala. The production process of the textile plant is labor-intensive.Guatemala is categorized by the World Bank as Lower Middle Income and its main trade partner is the United States, which is High Income. The population density in Guatemala is 129 people per square kilometer; the population density in the US is 33 people per square kilometer.
Ben is a low-income, low-skill workerin the United States who works for John Deere, which produces tractors for sale in the US and for export. John Deere has the largest market share of tractors in the world. The production process is capital-intensive.
Cat retired from her job in the financial industry and put her life savings into an artisanal toy-making company. Her toys are made of wood by hand by local workers, and sold primarily in local shops. She is hoping to convince high-income families to buy her toys instead of the Made-in-China, mass-produced toys sold at Walmart.

According to the factor model of trade policy, which of these people are predicted to support free trade and which will support protectionist policies? Explain your logic.Include a diagram for the theory, if appropriate. (7 points)
According to the sector model of trade policy, which of these people are predicted to support free trade and which will support protectionist policies? Explain your logic. Include a diagram for the theory, if appropriate. (6 points)
According to the partisan model of monetary and exchange rate politics, what are the exchange rate policy and monetary preferences for each of these people? Explain your logic.Include a diagram for the theory, if appropriate. (6 points)
According to the sectoral model of monetary and exchange rate politics, what are the exchange rate policy and monetary preferences for each of these people? Explain your logic. Include a diagram for the theory, if appropriate. (6 points)

Financial leverage

Explain why leverage (for real estate buyers, for example) enables very high returns when prices are rising but can cause insolvency when prices fall. Use the example of a house purchased with 90% debt, and what happens when home prices rise by 20%, versus what happens when prices fall by 20%. (7 points)
High leverage purchases could be prevented with financial regulation (for example, requiring a higher minimum down-payment on a house, or higher reserve requirements for a bank). Use the modern political economy approach (described by Frieden) to identify which sectors of society would be in favor of such regulation, and which sectors of society would be opposed to such regulation. Explain your logic for each. Try to identify at least two groups that would be in favor and two groups that would be opposed. (6 points)
Explain why financial liberalization (including capital mobility and financial deregulation) increases the risk of banking crisis. Use one example from one of the following countries to illustrate: the United States,Thailand, Indonesia, Spain, Ireland, or Iceland. Include the concept of Moral Hazard in your explanation. (6 points)
Explain why, using the Prisoners’ Dilemma framework, the use of high leverage is so common in the absence of financial regulation, even though a financial system with widespread high leverage is vulnerable to financial crisis. Use the Prisoners’ Dilemma framework in your explanation. Include in your discussion the following terms: Nash Equilibrium, Dominant Strategy, Pareto Inefficient (or Suboptimal), and/or Moral Hazard, as appropriate. (6 points)
EXTRA CREDIT: Why is international financial regulation more difficult to achieve in an era of globalization? (up to 3 points)

Dollarisation

From The Economist: “El Salvador is abolishing its currency, the colon, and adopting the dollar… The colon was pegged to the dollar back in 1994. Then, in January 2001, the currency began to be phased out... The government expects the colon to disappear completely by the end of 2003.Dollarisation may well make sense for El Salvador. Its economy, unlike Argentina's, is closely tied to that of the United States, which takes two-thirds of its exports… Salvadoreans have already started to benefit from dollarisation. The most obvious gain is lower interest rates. Consumer credit is growing. Companies and the government have been helped by cheaper international financing. And dollarisation has reduced transaction costs for firms.But dollarisation also poses challenges. Although Guatemala has legalised the dollar as a domestic currency in parallel with its own quetzal, many of El Salvador's other neighbours and economic competitors have floating exchange rates. Their (El Salvador’s neighbors’) currencies have devalued. To remain competitive, El Salvador has to respond with higher productivity and lower costs. Economic reforms have helped… Even so, there are worries. One is the government's budget deficit. Mainly because of the cost of rebuilding after the earthquakes, that rose to 3.7% of GDP last year. Unchecked, this risks driving up the cost of credit. The government has responded by cutting ministerial budgets by an average of 17% this year… In short, adopting the dollar is no panacea…”

Explain how this article relates to the Marcoeconomic Trilemma (a.k.a., the Unholy Trinity). Include the trilemma diagram in your answer.(7 points)
Look at the quote, “Its economy, unlike Argentina's, is closely tied to that of the United States.” Explain why having an economy closely tied to the United States makes El Salvador a better candidate for dollarization than Argentina. (6 points)
Look at the quote, “Salvadoreans have already started to benefit from dollarisation. The most obvious gain is lower interest rates.” Explain how dollarization in El Salvador may have led to lower interest rates. Include in your explanation a likely reason why interest rates were higher in El Salvador before dollarization. (6 points)
Look at the quote, “many of El Salvador's other neighbours and economic competitors have floating exchange rates. Their (El Salvador’s neighbors’) currencies have devalued. To remain competitive, El Salvador has to respond with higher productivity and lower costs.” Explain why the floating exchange rate of El Salvador’s neighbors means El Salvador needs higher productivity and lower costs to compete. You do not need to use a diagram of supply and demand curves, but you should include an explanation of how exchange rate adjustments.(6 points)
EXTRA CREDIT: Look at the quote, “Mainly because of the cost of rebuilding after the earthquakes, that (the government’s budget deficit) rose to 3.7% of GDP last year. Unchecked, this risks driving up the cost of credit. The government has responded by cutting ministerial budgets by an average of 17% this year.” Explain how dollarization relates to the rise in cost of credit and the need for budget cuts. Explain how this relates to the Exit, Voice, Loyalty Framework, and to the Political Trilemma of Globalization.

Multiple Choice Question Number One (2.5 points per question)

A public good is defined by two characteristics:

Majority rule and government provision
Non-excludability and non-rivalry
Positive externality and coercion
Political contestation and national interest
Government provision and national interest

According to Hegemonic Stability Theory,

The benefits that the hegemon gains from trade are so large that it is willing to bear the full cost of creating international trade rules.
The hegemon uses its military power to impose the costs of creating free international trade onto weaker nations.
The hegemon will take advantage of its military power to avoid the costs of free trade, and so the international system will not be stable unless a multilateral institution constrains the hegemon

True or False (according to Bruton): Through most of the 1950s, Taiwan and South Korea used trade and exchange rate policies to limit external competition.
EMS stands for:
Exchange Money System
European Monetary States
European Monetary System
Economic Monetary System
Exchange Mechanism System
The Plaza Accord was:
An agreement negotiated by the Reagan administration with four other governments to reduce the value of the dollar.
An agreement negotiated by the Reagan administration with four other governments to increase the value of the dollar.
A plan proposed by the Bush administration to bring the developing-country debt crisis to a close by converting commercial debt into bonds.
The collection of policy reforms advocated by US officials and by the IMF and World Bank staffs as the solution to the economic problems faced by developing countries.
Firms decide to conduct international transactions as multinational corporations (MNCs) rather than through the market (exports and imports) because of the interaction between:
The profit motive and low wages
Proprietary advantages and cost advantages
Locational advantages and market imperfections
The profit motive and locational advantages
Proprietary advantages and market imperfections
Resource endowments and managerial expertise
Which of these assertions were made in the Slate.com article by Paul Krugman?

“wherever the new export industries have grown, there has been measurable deterioration in the lives of ordinary people. Partly this is because the government cannot stand up to foreign direct investors to protect workers’ rights…”
“wherever the new export industries have grown, there has been measurable improvement in the lives of ordinary people. Partly this is because a growing industry must offer a somewhat higher wage than workers could get elsewhere in order to get them to move….”
“wherever import substitution industries have grown, there has been measurable improvement in the lives of ordinary people. Partly this is because closed economies increase the bargaining power of labor…”

Horizontal integration is defined as:
“An exchange-rate system in which governments permanently fix their exchange rates and introduce a single currency.”
“The rule that requires that any advantage extended to one WTO member government also be extended to all WTO members.”
“A form of industrial organization in which a single firm controls the different states of the production process.”
“A form of industrial organization that occurs when a corporation creates multiple production facilities, each of which produces the same good or goods.”
The reason the EU is not an optimal currency area is because
The average income per capita of wealthy nations such as Germany are over ten times higher than the average income per capita of poor nations such as Greece.
Citizens from EU member countries such as Greece are blocked by immigration policies from moving to countries such as Germany that may have more jobs.
Labor costs, gains in productivity, and government spending are far different in countries such as Germany than they are in countries such as Greece.
Countries such as Germany and Greece do not trade with one another.
Which of these statements would Rodrik agree with, regarding what has been learned from developing countries’ experience with Washington Consensus policies?
“There was nothing wrong with the Washington Consensus itself; it just had not been ambitious enough.”
“It is not enough to slash import tariffs and eliminate barriers to trade; open trade policies need to be underpinned by extensive reforms in public administration, by labor market “flexibility”, and by international trade agreements.”
“Poor countries suffer from multiple shortcomings, but not all of them need to be addressed at the same time for their economies to enjoy rapid growth for a while. The trick is to identify the most binding constraints that prevent entrepreneurs from investing in the modern industries that fuel economic growth.”
“Macroeconomic stability needs to be cemented by reforming fiscal institutions, giving central banks independence, and of course by better politics.”

Multiple Choice Question Number Two (2.5 points per question)

The post-Bretton Woods Era is characterized by:
Highly liberalized capital flows, trade, and immigration
Highly liberalized capital flows and trade but fairly restrictive immigration flows
Highly liberalized capital flows and immigration but fairly restrictive trade
Highly liberalized trade but restrictive capital flows and immigration
Nixon abandoned the dollar’s peg to gold because (more than one answer may be correct – write down the letter for all answers that are correct):
He didn’t want to reduce spending on the Vietnam War
He didn’t want to reduce domestic government spending
He didn’t want to raise taxes
He didn’t want to tighten monetary policy
The US was running a persistent trade surplus
The US was running a persistent trade deficit
French speculators were demanding gold for dollars
French speculators were demanding dollars for gold
The triple-shock on Latin American economies in 1979 and the early 1980s included:
A recession in the US, reduced interest rates in the US, and a fall in oil prices
A recession in the US, increased interest rates in the US, and a rise in oil prices
A recession in the US, reduced interest rates in the US, and a rise in oil prices
A recession in the US, the US abandoned its exchange rate peg to gold, and a rise in oil prices
A recession in the US, the US abandoned its exchange rate peg to gold, and new tariffs on imports by the US
The financial crises in the 1990s shared two similarities in their causes:
High budget deficits and corrupt governments
High budget deficits and heavy reliance on short-term foreign capital
High inflation and high trade deficits
Some form of fixed exchange rate and heavy reliance on short-term foreign capital
High budget deficits and some form of fixed exchange rate
Obsolescing bargain means:
An FDI incentive that expires in a number of years
An export processing zone (EPZ) that is available for a limited number of years
Bargaining power shifts to the host country over
Bargaining power shifts to the MNC over time
According to Reinhart and Rogoff, currency debasement is
A form of inflation
A type of recession
An exchange rate policy from ancient times
A high level of debt to equity ratio
A current account deficit is when
Exports are less than imports
Imports are less than exports
Financial inflows are less than financial outflows
Financial outflows are less than financial inflows
Government expenditures are less than taxes
In her 2012 speech, the Managing Director of the IMF, Christine Lagarde, said the world is facing a triple crisis:
Financial crisis, productivity crisis, and government spending crisis
Trade balance crisis, financial crisis, and social crisis
Economic crisis, environmental crisis, and social crisis
Debt crisis, exchange rate crisis, and financial crisis
If an industry has locational advantages, such as large deposits of a natural resource in certain countries, and the firm has specific assets, then the type of government we would expect to see in that industry is:
A horizontally integrated MNC
A vertically integrated MNC
A horizontally integrated domestic firm
A vertically integrated domestic firm
The predominant ideology during the Bretton Woods period was
Classical liberalism
Neo-classical liberalism
Neo-liberalism
Embedded liberalism
Christian socialism
Chicago School
Washington Consensus