Ch 1: Introduction and Institutions

Describe the three kinds of evidence economists use to support the assertion that economies open to the world grow faster than economies that are closed. These are (1) casual empirical evidence of historical experience; (2) economic logic and deductive reasoning; and (3) evidence of statistical comparisons of countries

*1. Casual empirical evidence of historical experience.* The historical evidence examines the experiences of countries that tried to isolate themselves from the rest of the world. First, not only did trade protection exacerbate the Depression of the 1930s, but it also led to the misery and tragedy of World War II. Second, an examination of countries such as former East and West Germany, North and South Korea, and other countries with the same historical, economic, and ethnic background that were divided by war, indicate that those who closed their economies from the rest of the world suffered in terms of prosperity and environmental degradation. East Asia experienced an economic takeoff when it decided to integrate with the rest of the world, while Latin America, which had the same economic background as East Asia but chose to remain partially closed, experienced mediocre growth. *2. Evidence based on economic models and deductive reasoning.* The logic of economic theory also suggests a strong causal relation between trade and faster economic growth. The following is a summary of this linkage: Following Adam Smith, David Ricardo proved that comparative advantage leads to trade and this in turn leads to the reallocation of resources and the improvement of the standard of living of any nation, large or small. Modern trade theory also makes the case for exports and open trade as the causes for economic expansion. Exports and open trade foster competition, innovation, and learning by doing and bring international best practices to the attention of domestic producers, spurring greater efficiency and export expansion. This helps domestic producers to realize economies of scale when they attempt to produce for the world market rather than for their own limited base of domestic consumers. Larger markets create incentives for firms to engage in research and development, and allow countries to import important production inputs and foreign capital by minimizing foreign exchange constraints. They facilitate the transfer of technology and managerial skills. It follows that open trade and exports increase the demand for the country's output and therefore contribute strongly to positive economic growth. *3. Evidence from statistical comparisons of countries.* Even though the statistical evidence is not quite conclusive (mainly due to measuring trade policy), the evidence of statistical comparison of countries (cross-sectional time series) indicates that countries benefit from open trade.

*T/F* In the 1960s, many countries began to encourage financial integration by increasing the openness of their capital markets

*False* *In the 1970s*, many countries began to encourage financial integration by increasing the openness of their capital markets

*T/F* In qualitative terms, the differences between today and a hundred years ago may not be as great as many people imagine, but quantitative, a number of additional features of the world economy separate the first decade of the twenty-first century from the first decade of the twentieth.

*False* In *quantitative* terms, the differences between today and a hundred years ago may not be as great as many people imagine, but *qualitatively*, a number of additional features of the world economy separate the first decade of the twenty-first century from the first decade of the twentieth.

*T/F* Labor is more mobile than it was in 1900

*False* Labor is *less* mobile than it was in 1900. Ex: In 1890 14.5% of the US population was foreign born, while in 2010, the figure was 12.9%

*T/F* Our current wave of economic integration began in the 1940s

*False* Our current wave of economic integration *began in the 1950s, with the reduction of trade barriers after WWII*

*T/F* Since the end of WWII, world output has grown much faster than world trade

*False* Since the end of WWII, *world trade has grown much faster than world output*

*T/F* The proposition that today's economies are more integrated than at any other time in history is easily demonstrated

*False* The proposition that today's economies are more integrated than at any other time in history is *not simple to demonstrate*

*T/F* Between the onset of WWI in 1914 and the end of WWII in 1945, the world economy suffered a series of human-made catastrophes that de-integrated national economies

*True*

*T/F* Countries with higher trade to GDP ratios do not necissarily have lower barriers to trade

*True* In general, large countries are less dependent on international trade because their firms can reach an optimal production size without having to sell to foreign markets. Consequently, smaller countries tend to have higher ratios of trade-to-GDP

*T/F* In 1900, many nations had open door immigration policies, and passport controls, immigration visas, and work permits were exceptions rather than rules.

*True* The movement of people was severely restricted by the two world wars and the Great Depression of the 1930s. In the 1920s, during the interwar period, the United States sharply restricted immigration with policies that lasted until the 1960s, when changes in immigration laws once again encouraged foreigners to migrate to the United States.

What technologies paved the way for new growth in economic integration between 1870 and 1913?

- transatlantic cables - steam-powered ships - railroads - radio telephony

Measurement of capital flows is difficult because there are several ways to measure them. The most basic distinction between capital flows is between:

1. *flows of financial capital* (representing paper assets such as stocks, bonds, currencies, bank accounts) 2. flows of capital representing physical assets, or *foreign direct investment (FDI)** (such as real estate, factories, and businesses

When we compare international capital flows today to a century ago, what are two points to keep in mind?

1. *savings and investment are highly correlated* (high savings = high rates of investment; low savings = low investment) *If there were a single world market in which capital flowed freely and easily, this would not necessarily be the case. Capital would flow from countries with abundant savings and capital to countries with low savings and capital, where it would find its highest returns.* 2. a variety of technological improvements increased capital flows in the 1800s, as they are doing today. Transoceanic cables and radio telephony have already been mentioned, but capital flows also increased in the late 1800s because there were new investment opportunities such as national railroad networks and other infrastructure, both at home and abroad.

Why is it easy to overestimate integration today?

1. Because many overlook the period between 1870 and 1913, when new technologies such as transatlantic cables, steam-powered ships, and the railroad created growth in economic integration. 2. Instantaneous communications and rapid transportation, together with the easy availability of foreign products, often cause us to lose sight of the fact that most of what we buy and sell never makes it out of our local or national markets. (Today, about 83.4% of of US goods are produced domestically compared to 92% in 1980)

What evidence supports the belief that openness to the world economy is a superior policy to closing off a county?

1. Casual empirical evidence of historical experience 2. Evidence based on economic models and deductive reasoning 3. Evidence from statistical comparisons of countries

As trade barriers came down during the second half of the 20th century, two other trends began to intensify economic integration between countries. What new issues were raised by these two trends?

1. Greater interest in the consequences of different domestic policies *makes trade negotiations more difficult and creates widespread discussion of labor, environmental, and other standards that may affect trade flows* 2. Greater participation in the production of a single product by firms in multiple countries *leads to concerns about the impact of trade on national economies, employment, and working conditions*

What are the benefits created by capital flows?

1. Investment 2. New technology 3. Higher consumption 4. Lending

As trade barriers came down during the second half of the 20th century, what two other trends began to intensify economic integration between countries?

1. Lower trade barriers exposed new obstacles to international trade created by countries' domestic policies 2. Technologically complicated goods such as smartphones and automobiles are made of components produced in more than one country

What a potential problems created by increased international economic integration?

1. More competition for firms and workers 2. Capital flows increase the risk of spreading financial crises internationally 3. Rising immigration means more competition in labor markets and greater social tensions 4. International organization may reduce national sovereignty 5. Free-trade agreements means more competition and more pressure on domestic workers and firms

In what sense is the U.S. economy more integrated with the world today than it was a century ago? In what ways is it less integrated?

1. The WTO's Trade Profile implies that the US trade-to-GDP ratio is about 150% greater today than it was in 1913 [(28.3-11.2)/11.2=1.53]. However, this is consistent with the observation that world trade has been growing faster than world output, at least since 1950. 2. In terms of labor flows: the US is less integrated with the world economy than it was in 1890 or 1900, when it had an open door immigration policy. (14.5% in 1890 v. >8% in 1990 and 12% today) 3. Capital flows are more difficult to generalize due to various measures. a Absolute volume of capital flows has increased dramatically but as a share of world GDP it is probably no more than it was at the turn of the twentieth century, maybe less. b The level of investment in nearly all countries is still highly correlated with domestic savings rates c What is different: the ease capital crosses international boundaries (lower transaction costs) and the greater variety of assets traded d The need to protect against exchange rate risk is a key component of today's international financial markets and is a primary difference from the fixed exchange rate standard of the past. The incidence of financial crises has not increased and, as a metric of integration, it implies no increase in capital market integration. 4. The growth of regional trade agreements is also an indicator of increased integration. 5. A growing role for international institutions such as the IMF or World Bank may also indicate an increase in international integration.

What are the 12 themes in international economics?

1. The gains from trade and new trade theory 2. Wages, jobs, and protection 3. Trade deficits 4. Regional trade agreements (RTAs) 5. The resolution of trade conflicts 6. The role of international institutions 7. Exchange rates and the macroeconomy 8. Financial crises and global contagion 9. Capital flows and the debt of developing countries 10. Latin America and the world economy 11. Export-led growth in East Asia 12. China and India in the world economy

While the relative quantity of capital flows today may not be that much different for many countries, there are some important qualitative differences. What are these qualitative differences?

1. There are many more financial instruments available 2. Foreign exchange transactions are now the biggest component of international capital movements (used to have less risky, fixed exchange rates) 3. The cost of foreign exchange transactions have fallen significantly

What are the problems created by financial flows?

1. They have outpaced our ability to monitor and supervise 2. They frequently cause financial crises 3. Cause macroeconomic and financial volatility

What additional features of the world economy separate the first decade of the 21st c. from the first decade of the 20th c. in qualitative terms?

1. deeper integration 2. multilateral organizations 3. regional trade agreements

What are 3 measures of the degree of international economic integration?

1. trade flows 2. factor (labor and capital) movement 3. the similarity of prices in separate markets

How can globalization and international economic integration be measured?

1. trade flows 2. factor movements 3. convergence of prices (goods, factors, and assets)

Today's global economy is not the first instance of a dramatic growth in economic ties between nations, however, as there was another important period between:

1870 and 1913

Does a low trade-to-GDP ratio indicate that a country is closed to trade with the outside world?

A relatively small ratio does not necessarily mean that an economy is intentionally closed to the outside world. Large countries like the United States have large domestic markets that enable firms to specialize and produce in volume in order to attain an optimal scale. Specialization and high volume in manufacturing is often associated with increased productivity, so firms in large markets can achieve the highest possible level of productivity without having to sell to foreign markets. Firms located in smaller countries have to trade their output across international boundaries if they want to have the same technology and the same level of productivity. Consequently, large countries tend to have lower trade-to-GDP ratios regardless of their trade policies.

Trade and capital flows were described and measured in relative rather than absolute terms. Explain the difference. *Which term seems more valid—relative or absolute? Why?*

Absolute values are the dollar amounts of trade and capital flows. Relative values are the ratio of dollar values to GDP. *Relative values are a better indicator of the importance of trade and capital flows since they are proportional to the size of national economies.* Large economies like the United States may have large export and import values, but the importance of trade to the national economy is not nearly as great as it is for other economies. The United States is a large exporter and importer, but the national economy is so large that trade is much less important for the United States than it is for many smaller countries such as Canada, Belgium, or The Netherlands.

Economists sometimes refer to the reduction of tariffs and the elimination of quotas as ____ integration and negotiations over domestic policies that impact international trade as ____ integration.

Economists sometimes refer to the reduction of tariffs and the elimination of quotas as *shallow* integration and negotiations over domestic policies that impact international trade as *deep* integration.

Why should goods that can move freely from a low-cost to a high-cost region experience price convergence?

Goods that can move freely from a low-cost to a high-cost region experience price convergence *as goods move from where they are plentiful and cheap to where they are relatively scarcer and more expensive*

In ____ terms, the differences between today and a hundred years ago may not be as great as many people imagine, but ____, a number of additional features of the world economy separate the first decade of the twenty-first century from the first decade of the twentieth.

In *quantitative* terms, the differences between today and a hundred years ago may not be as great as many people imagine, but *qualitatively*, a number of additional features of the world economy separate the first decade of the twenty-first century from the first decade of the twentieth.

Why do smaller countries tend to have higher ratios of trade-to-GDP?

In general, large countries are less dependent on international trade because their firms can reach an optimal production size without having to sell to foreign markets. Consequently, smaller countries tend to have higher ratios of trade-to-GDP

How has international economic integration made countries vulnerable?

It has made them more vulnerable to economic problems that have become more easily transmitted from one place to another

In relative terms, international capital flows may not be much greater today than they were a hundred years ago, although they are certainly greater than they were fifty years ago. Qualitatively, however, capital flows are different today. Explain.

Major qualitative difference between late nineteenth and late twentieth century capital flows include the fact that there are many more types of financial instruments available now compared to a century ago. These instruments can be finely tailored to the income and risk preferences of investors. Secondly, a large share of the total flow of capital across borders is related to the need to protect against fluctuations in the value of currencies. This use of international capital markets was not as necessary when nations operated within fixed exchange rate systems. Third, the transaction costs of participating in international capital markets are much lower today than it was a century ago.

Since the end of WWII, world ____ has grown much faster than world ____

Since the end of WWII, *world trade* has grown much faster than *world output*

Since the end of WWII, world trade has grown much faster than world output. One way to show this is to:

Since the end of WWII, world trade has grown much faster than world output. One way to show this is to: *estimate the ratio of exports by all countries to total production by all countries* *Total exports/total production*

What are the new issues in international trade and investment? In what sense do they expose national economies to outside influences?

The new issues involve policy differences between nations that until recently were considered the exclusive responsibility of local or national governments. Examples include labor standards, environmental standards, competition or antitrust policies, and industrial support policies. Negotiations between nations potentially give foreign interests a voice in setting domestic policy. The scope and the depth of the negotiations determine how great a voice foreigners will have. It is often the case, however, that negotiations either occur or are proposed because some aspect of domestic policy is perceived by foreigners as a barrier to trade, and they seek to alter the domestic policy that created it.

Describe the pattern over the last century shown by the trade-to-GDP ratio for leading industrial economies.

The ratio fell between 1913 and 1950, but then began to rise relatively rapidly. The main causes of the pattern shown in Figure 1.1 are the two world wars and the Great Depression of the 1930s, and changes in trade policy accompanying that period. By 2000, the ratios were mostly higher than they were before World War I. Another pattern the chapter notes is that the ratio is smaller for the large population countries of Japan and the United States, and higher for The Netherlands, with its small population.

The similarity of prices refers to the fact that integrated economies:

The similarity of prices refers to the fact that integrated economies *have price differences that are relatively small and are due mainly to differences in transportation costs*

The trade-to-GDP ratio is a measure of the relative importance of trade to a national economy. It is measured by the ratio of exports plus imports to GDP.

The trade-to-GDP ratio

What does the trade-to GDP measure?

The trade-to-GDP ratio is a measure of the relative importance of trade to a national economy. It is measured by the ratio of exports plus imports to GDP

What does the trade-to-GDP ratio measure? Does a low value indicate that a country is closed to trade with the outside world?

The trade-to-GDP ratio is a measure of the relative importance of trade to a national economy. It is measured by the ratio of exports plus imports to GDP. A relatively small ratio does not necessarily mean that an economy is intentionally closed to the outside world. Large countries like the United States have large domestic markets that enable firms to specialize and produce in volume in order to attain an optimal scale. Specialization and high volume in manufacturing is often associated with increased productivity, so firms in large markets can achieve the highest possible level of productivity without having to sell to foreign markets. Firms located in smaller countries have to trade their output across international boundaries if they want to have the same technology and the same level of productivity. Consequently, large countries tend to have lower trade-to-GDP ratios regardless of their trade policies.

Compute the trade-to-GDP ratio.

The trade-to-GDP ratio is measured by the ratio of: *(Exports + Imports)/GDP*

Trade to GDP ratio =

Trade to GDP ratio = (exports + imports)/ GDP

*T/F* The advent of the Internet in the 1990s, along with other elements of the telecommunication revolution, pushed economic integration to new levels as multinational firms developed international production networks and markets became ever more tightly linked

True

Why did national economies de-integrate between the period of 1914 and 1945?

Two world wars and a global depression caused most countries to close their borders to foreign goods, foreign capital, and foreign people.

Which of the following was a demonstration of international economic integration? a. The 2007-08 crisis in the US housing sector b. The Russian Crisis of 1998-99 c. The Asian Crisis of 1997-98 d. The 206 US corporate scandals

a. The 2007-08 crisis in the US housing sector b. The Russian Crisis of 1998-99 c. The Asian Crisis of 1997-98

Which of the following enable most goods to move from one country to another without major obstacles and at a relatively low cost? a. instantaneous communication b. trading blocs c. modern transportation d. relatively open trading systems

a. instantaneous communication c. modern transportation d. relatively open trading systems

____ values are the dollar amounts of trade and capital flows

absolute values

If we compare the size of capital flows today to the previous era of globalization, flows today:

are much larger but mainly because:

Our current wave of economic integration began in the: a. 1940s with the reduction of trade barriers b. 1950s with the reduction of trade barriers after WWII c. 1970s when countries began encouraging financial integration by increasing the openness of their capital markets d. 1990s with the Advent of the Internet

b. 1950s with the reduction of trade barriers after WWII

Goods that can move freely from a low-cost to a high-cost region should experience: a. price reduction b. price equalization c. price convergence d. price inflation

c. price convergence Goods that can move freely from a low-cost to a high-cost region should experience *price convergence as goods move from where they are plentiful and cheap to where they are relatively scarcer and more expensive*

The advent of the Internet in the 1990s, along with other elements of the telecommunication revolution, pushed economic integration to new levels as multinational firms:

developed international production networks and markets became ever more tightly linked

____ are flows of assets representing physical assets, such as real estate, factories, and businesses

foreign direct investment (FDI)

National regulations governing labor, environmental, and consumer safety standards; rules governing investment location and performance; rules defining fair and unfair competition; rules on government "buy-national" programs; and government support policies for specific industries—all have little impact on trade until:

formal trade barriers start to fall and trade volume increases. As long as tariffs were high and trade flows were limited, they did not matter much to trade relations. Once tariffs fell, however, many forms of domestic policies began to be viewed as barriers to increased trade.

Deep integration is much more contentious than shallow integration and much more difficult to accomplish because:

it involves domestic policy changes that align a country with rules that are created abroad, or at least negotiated with foreign powers

Today's lower transaction costs for foreign investment mean that:

it is less expensive to move capital across international borders

As national economies become more interdependent, labor and capital should:

move more easily across international borders

____ values are a better indicator of the importance of trade and capital flows since they are proportional to the size of national economies

relative values

____ values are the ratio of dollar values to GDP

relative values

____ values are the ratio of dollar values to GDP. ____ values are a better indicator of the importance of trade and capital flows since they are proportional to the size of national economies

relative values

Why are relative values a better indicator of the importance of trade and capital flows?

relative values are a better indicator of the importance of trade and capital flows *since they are proportional to the size of national economies*

One important measure of international trade in a nation's economy is:

the trade-to-GDP ratio

____ is the value of all final goods and services produced inside a nation during some period, usually one year

the trade-to-GDP ratio

Gross domestic product (GDP) is a measure of:

total production

____ are the costs of obtaining market information, negotiating an agreement, and enforcing the agreement

transaction costs

*T/F* A large share of the total flow of capital across borders is related to the need to protect against fluctuations in the value of currencies. This use of international capital markets was not as necessary when nations operated within fixed exchange rate systems

true

*T/F* If we compare the size of capital flows today to the previous era of globalization, flows today are much larger but mainly because economies are larger.

true

*T/F* In general, economists remain firmly convinced that the benefits of trade outweigh the costs.

true

*T/F* In quantitative terms, the differences between today and a hundred years ago may not be as great as many people imagine, but qualitatively, a number of additional features of the world economy separate the first decade of the twenty-first century from the first decade of the twentieth.

true

*T/F* Labor is less mobile than in 1900 due to passport controls and work permits, but capital is more mobile and encompasses a larger variety of financial forms.

true

*T/F* The question as to whether we are more economically integrated today or some period in the past is not academic

true

*T/F* To some extent, the distinction between the two types of capital flows (physical and paper) is immaterial because both represent shifts in wealth across national boundaries and both make one nation's savings available to another

true

*T/F* While the relative quantity of capital flows today may not be that much different for many countries, there are some important qualitative differences.

true