This Document Contains Chapters 18 to 19 CHAPTER 18 OPEN-MARKET MACROECONOMICS Chapter Overview In this chapter, we opened up the national economy to understand how countries trade and invest with each other. When we add net exports to our GDP equation, we get an interesting result: The difference between what a country buys and sells is also equal to the level of foreign investment. In effect, if a country is buying more than it is selling, it needs to borrow money from abroad to pay for its imports. This important equality is called the balance-of-payments identity. The tight link between the trade balance and capital flows is the key to understanding issues such as the U.S. trade deficit and the U.S. debt with China. We looked at two explanations for the trade deficit with China, which turn out to be different sides of the same coin. The first explanation is that the United States is not saving nearly as much as China and is relying on investment from other countries. From the balance-ofpayments identity, we know that if foreign investment is high, then there must also be a trade imbalance. The second explanation is that exports from China are artificially cheap because the Chinese currency is set at a price below what it should be—that is, below its market price. Cheap Chinese exports mean that the balance of trade is negative, and the United States needs to borrow money to pay for its spending. In extreme cases, we saw how international debt and fixed exchange rates can tip countries into economic crises. As the world continues to become more and more interlinked, economic policy in one part of the world will have global effects. Macroeconomics may seem more abstract than microeconomics, with lots of moving parts. Yet trade policy, government fiscal policy, monetary policy, and the decision of how to set the exchange rate affect the daily lives of every citizen, usually in ways that are hard to see. In the concluding chapter, we will apply the lessons you’ve learned throughout the book to one of the most stubborn problems in economics—international poverty. Learning Objectives LO 18.1 Define the balance of trade and describe the general trends of U.S. trade. LO 18.2 Define portfolio investment and foreign direct investment. LO 18.3 Explain the connection between the balance of trade and net capital outflow. LO 18.4 Describe the determinants of international capital flows using the demand and supply for international loanable funds. LO 18.5 Show how the international market for loanable funds can be used to explain events in the international financial system. LO 18.6 Describe exchange rate appreciation and depreciation and understand their effects on trade. LO 18.7 Describe the determinants of demand and supply in the forex market. LO 18.8 Explain fixed and floating exchange rates. LO 18.9 Describe why monetary policy is ineffective when maintaining a fixed exchange rate. LO 18.10 Describe the difference between the real and nominal exchange rates. LO 18.11 Describe the role of the IMF and how financial crises are created by excessive debt and unsustainable exchange rates. Chapter Outline FROM FACTORY TO FIGURES International Flows of Goods and Capital Imports and Exports (LO 18.1) Foreign Investment (LO 18.2) BOX FEATURE: WHAT DO YOU THINK? – ARE SWEATSHOPS GOOD OR BAD? Balance of Payments (LO 18.3) International Capital Flows Determinants of International Capital Flows (LO 18.4) BOX FEATURE: REAL LIFE – ICELAND AND THE BANKING CRISIS Effects of Foreign Investment (LO 18.5) Can a Country Save Too Much? Exchange Rates The Foreign-Exchange Market (LO 18.6) A Model of the Exchange-Rate Market (LO 18.7) Exchange-Rate Regimes (LO 18.8) BOX FEATURE: REAL LIFE – DOLLARIZATION: WHEN NOT IN THE U.S. . . . BOX FEATURE: REAL LIFE – THE MAN WHO BROKE THE BANK OF ENGLAND Macroeconomic Policy and Exchange Rates (LO 18.9) The Real Exchange Rate (LO 18.10) Global Financial Crises (LO 18.11) The Role of the IMF Debt Crises Exchange-Rate Crises BOX FEATURE: FROM ANOTHER ANGLE – COOLING DOWN HOT MONEY Beyond the Lecture Class Discussion: Imports and Exports (LO 18.1) Have students view U.S. trade data from the U.S. Census Bureau and then listen to this podcast by Don Boudreaux, where he talks about trade deficits and global trade. Discuss the following: 1. What has been the general trend of U.S. trade over time? 2. What are the benefits and potential costs of trade? 3. What does it mean to run a trade deficit? Is this a problem? Class Discussion: Foreign Investment (LO 18.2) In order to start a discussion on foreign direct investment, consider reviewing the World Bank’s Doing Business Report with students. Specifically point out the rankings in the report, then discuss the following: 1. While there are many issues to consider, why do you think some countries attract more foreign direct investment than others? 2. What factors impact foreign direct investment? 3. How does foreign direct investment impact the investment country and the investor? Class Discussion: The Foreign-Exchange Market (LO 18.6) Have students examine exchange rates using this exchange rate calculator, and discuss the following: 1. What causes exchange rates to change? 2. How do exchange rate changes impact individuals and firms? Class Discussion: The Foreign-Exchange Market (LO 18.6) Have students read this brief article on U.S. and Chinese currency, and discuss the following: 1. How do exchange rates impact trade? 2. What happens to relative prices if a country’s currency appreciates or depreciates? 3. Could a country benefit from keeping its currency undervalued? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. The United States has ran a trade __________ since _________. [LO 18.1] A. surplus; 1983 B. surplus; 1945 C. deficit; 1970 D. deficit; 1992 2. John (an American) has a retirement account in which some of his money is invested in German and Japanese companies. This is an example of__________. [LO 18.2] A. foreign direct investment B. foreign portfolio investment C. U.S. government debt D. a trade surplus 3. The balance-of-payments identity shows that net exports must______ [LO 18.3, 18.4] A. equal net capital outflow B. equal net capital inflow C. be greater than net capital outflow D. result in FDI equaling foreign portfolio investment 4. Suppose that your friend from India visits the United States, and that he brings 75,000 Rupees which are exchanged for $1,100. Assuming exchange rates don’t change, when you visit your friend in India and bring $2,000, how many Rupees will you be able to exchange your dollars for__________ Rupees. [LO 18.6, 18.7] A. 80,235 B. 92,667 C. 126,980 D. 136,363 Feedback: The exchange rate is 1 US dollar equals 68.18 Indian Rupees. 5. Suppose that the Japanese yen appreciates relative to the US dollar. Which of the following will result? [LO 18.6] A. U.S. goods become cheaper for Japanese buyers B. U.S. goods become more expensive for Japanese buyers C. Japanese goods become cheaper for American buyers D. American exports to Japan will decrease Feedback: With the yen increasing in value, a yen will buy more dollars. That means the yen can buy more American goods. Solutions to End-of-Chapter Questions and Problems Review Questions 1. What happens to the U.S. balance of trade as oil prices rise? [LO 18.1] Answer: The U.S. is a large net importer of oil. In fact, about one-third of our usual trade deficit is net oil imports. If oil prices rise faster than the quantity demanded of oil falls due to its higher price (in other words, if oil is inelastically demanded), then an increase in oil prices will cause an increase in the dollar value of imported oil. The U.S. balance of trade will fall. 2. Suppose a presidential candidate criticizes his opponent by saying his opponent’s economic policies have made the dollar weaker and cost American factory workers their jobs. What would be your response? [LO 18.1] Answer: This presidential candidate is making no sense. A weak dollar makes our factory exports cheaper for foreigners to buy and makes imports that compete with our domestic factories more expensive. Thus, a weak dollar helps factory workers keep their jobs. 3. Why would a company want to make a direct investment in countries where the company’s home currency has higher purchasing power? [LO 18.2] Answer: If a company’s home currency has a higher purchasing power in a foreign country, that company should be able to purchase labor, land, and factory equipment more cheaply in the foreign country than at home. Thus it makes sense to expand the company’s operations into the foreign country utilizing direct investment. 4. Part of the North American Free Trade Agreement (NAFTA) opened the Mexican stock market to U.S. and Canadian investors for the first time. How would this affect direct and portfolio foreign investment in Mexico? [LO 18.2] Answer: Direct investment is when a foreign company or investor “directly” builds a new factory or store. Portfolio investment is when a foreign investor purchases financial assets in a country. This provision of NAFTA probably wouldn’t have any effect on direct investment, but portfolio investment would rise as foreign investors have an increased ability to purchase Mexican financial assets through the Mexican stock market. 5. If many factories that once made goods in the United States move to Mexico, what must also happen in order to correct the balance of payments in the United States? [LO 18.3] Answer: NCO = NX. If U.S. companies are moving factories to Mexico, they are engaging in direct foreign investment, which increases NCO. To balance this out, net exports (NX) must also increase at the same time. 6. Critics of NAFTA argued that opening our borders to free trade with Mexico would result in U.S. firms moving all of their factories to Mexico and the United States running large trade deficits with Mexico. Comment on the concerns of these critics using your knowledge of international trade and net capital flows. [LO 18.3] Answer: This criticism should not be a concern. If domestic firms increase their direct investment in Mexico, NCO rises—meaning that net exports must also rise to keep the economy in equilibrium. The U.S. would be running trade surpluses, not trade deficits. If the U.S. begins running large trade deficits with Mexico, NCO must fall in order to keep the economy in equilibrium. Thus, under this scenario Mexican firms and individuals would be investing in the U.S. Either one of the critics’ fears may come true, but they both can’t be true at the same time. 7. Rating agencies rate countries on the perceived riskiness of investing in their economies. Standard and Poor’s, one of the main rating agencies, downgraded the credit rating for U.S. Treasury bonds in 2011. According to this chapter, what impact should the downgrading have had on net capital outflows and interest rates? Why? [LO 18.4] Answer: If the U.S. is now perceived as riskier, fewer investors will be willing to invest in the U.S. NCO will rise, shifting the I + NCO curve to the right. The equilibrium interest rate will rise. 8. The interest rate on 10-year U.S. Treasury bonds just before Standard and Poor’s downgraded the U.S. credit rating was 2.47 percent. One year later, the interest rate on these bonds had fallen to 1.60 percent. How can one explain this result that seems to contradict the findings of this chapter? [LO 18.4] Answer: There are two potential explanations here. First, we could have had a violation of the “all other things equal” or ceteris paribus condition. For example, while a downgrade of U.S. debt alone would shift I + NCO right, if Standard and Poor’s simultaneously downgraded many other foreign countries by even more, the net effect might be a leftward shift of NCO + I. Alternatively, a large fall in the demand for investment funds in the U.S. would shift I + NCO left, counteracting the initial rightward shift in I + NCO. Finally, a large increase in savings would shift S right, which, if large enough, could more than counteract the rightward shift in NCO + I. The second explanation might be that no one put any faith in Standard and Poor’s judgment about the risk of U.S. debt and simply ignored its downgrade. This might be a reasonable explanation considering S&P had rated mortgage-backed securities with its highest possible grade only months before the housing meltdown made many of these financial instruments worthless. 9. List three policies that a government could engage in that would reduce interest rates. [LO 18.5] Answer: The government either needs to shift the I + NCO curve left or shift the savings curve (S) right. They can shift S right by encouraging savings (e.g., subsidizing savings through IRA or 401(k) plans or lowering tax rates on interest, dividends, or capital gains) or discouraging consumption (e.g., raising consumption taxes). The government can also directly increase S itself by reducing budget deficits or increasing budget surpluses. It can shift I + NCO left by discouraging investment (which would lower interest rates but be bad for long-term growth) or by engaging in plans that decrease NCO by convincing domestic savers to keep their savings in the country or encouraging foreign investors to bring money to the country (e.g., engaging in actions that make investors feel safe at home, reducing barriers for foreigners to invest, or raising barriers for domestic citizens to invest abroad). 10. A country doubles its rate of saving. How is this likely to affect the equilibrium interest rate and net capital outflow? What is the impact on the trade balance? [LO 18.5] Answer: This is likely to decrease the equilibrium interest rate as the supply of saving curve shifts to the right. This will increase net capital outflow as people seek higher rates of return in other countries. The value of the country's currency will decrease under a floating exchange rate system because the demand for the local currency will decline. The trade balance (exports - imports) will increase because the decrease in the value of the country's currency will increase exports and decrease imports. 11. Suppose the exchange rate value of the dollar depreciates. Who wins and who loses? [LO 18.6] Answer: When the dollar depreciates, our goods become relatively cheaper so this will benefit people who travel to our country, firms that export our goods, and people who want to buy our assets. Anyone who wants to buy foreign goods will not benefit, such as domestic residents who want to travel to foreign countries and domestic residents who want to buy imported goods or financial assets from other countries. 12. Suppose the exchange rate was 102 yen per dollar in 2014 and 110 yen per dollar in 2015. Did the dollar appreciate or depreciate? What about the yen? [LO 18.6] Answer: Because you must now pay more yen in exchange for one dollar, the dollar has increased (appreciated) in value and the yen has decreased (depreciated) in value. 13. Identify the main reasons why people convert one currency into another currency. [LO 18.7] Answer: People convert currency to buy goods and services from another country. They also sometimes engage in speculation and buy currency if they think it will increase in value. Foreign investors need to convert their home currency into the local currency to engage in direct foreign investment or portfolio investment. 14. During a recession the central bank lowers interest rates. How does this affect the exchange rate and net exports? [LO 18.7] Answer: During a recession, the central bank lowers interest rates. Under a floating exchange rate system, the value of the currency will depreciate because capital outflow will increase as people move their wealth to other countries where interest rates are relatively higher. Net exports (exports - imports) will increase because when the currency decreases in value, exports become relatively cheaper and imports become relatively more expensive. 15. A country has a fixed exchange rate. If world interest rates rise, what will the country have to do to maintain its fixed exchange rate? Has the fixed exchange rate become relatively more undervalued or overvalued? [LO 18.8] Answer: If world interest rates rise, the country will have to buy domestic currency and sell foreign currency to maintain the fixed exchange rate because there will be more capital outflow. The fixed exchange rate has become relatively more undervalued. 16. Suppose that in response to a severe recession, a country with an overvalued currency and a fixed exchange rate moves to a floating exchange rate system. Who are the winners and losers in this move? [LO 18.8] Answer: Because the currency was previously fixed and overvalued, the move to a floating exchange rate will cause the exchange rate to depreciate. Exporters and firms that compete against imports (as well as these firms’ workers) are the winners as their products now become cheaper and more competitive against foreign goods. 17. A country operates under a flexible exchange rate system. When the central bank lowers the interest rate during a recession, how does this affect investment and net exports, and ultimately aggregate demand? What if the exchange rate was fixed instead? [LO 18.9] Answer: When the central bank lowers the interest rate during a recession, investment spending will increase because it is cheaper for firms to borrow, the exchange rate value of the currency will decrease because there is more capital outflow, and net exports will increase because of the change in the exchange rate. The aggregate demand curve will shift to the right because spending is higher. If the exchange rate was fixed instead, then the central bank would not be able to use monetary policy to change the interest rate because any change in the interest rate would move the exchange rate away from its fixed value. 18. What are the advantages to fixing the exchange rate at an undervalued level? What are the disadvantages? [LO 18.9] Answer: Fixing the exchange rate at an undervalued level will increase exports and decrease imports. This will be an advantage to those who exports goods and a disadvantage to those who import goods. 19. Discuss what would happen to the real exchange rate between the U.S. and Australia if oil prices fell, which dramatically reduced the cost of transporting goods [LO 18.10] Answer: If transportation costs between Australia and the U.S. fall, we should expect the real exchange rate between the two countries to converge to 1. When the U.S. dollar price is converted to Australian dollars using the nominal exchange rate, this value should equal the Australian dollar price. 20. Is it ever possible for a country’s nominal exchange rate to be depreciating while its real exchange rate is appreciating? Explain. [LO 18.10] Answer: Yes, it is possible for a country’s nominal exchange rate to be depreciating while its real exchange rate is appreciating. EXr = EX × (Ph /Pf). If the nominal exchange rate is depreciating this means EX is falling. EXr could still be rising as long as (Ph /Pf) is rising faster than EX is falling. 21. Foreign investors in a country become worried about the stability of the government due to its rising debt level. What do you expect to happen to the interest rate and the exchange rate value of the country’s currency, assuming the country has a floating exchange rate? [LO 18.11] Answer: Under a floating exchange rate, we would expect the interest rate in the country to increase due to capital outflow, and the exchange rate value of the currency will decrease in value (depreciate) due to an increase in the supply of the country's currency and an increase in the demand for the foreign currency. 22. Foreign investors in a country become worried about the stability of the government due to its rising debt level. How might the IMF help avert a financial crisis in this country? [LO 18.11] Answer: If foreign investors are worried about a country's ability to repay its debts, then they will be reluctant to make more loans to the country, and they may wish to remove funds from this country. This can cause a financial crisis if the country is unable to repay foreign investors. The IMF can step in and act as a lender of last resort. Additionally, the IMF may require the country to reduce its budget deficit and pursue contractionary monetary policy in order to reduce inflation. Problems and Applications 1. Suppose total U.S. exports in the month of June were $122.9 billion and total imports from foreign countries were $192.4 billion. What was the balance of trade? [LO 18.1] Answer: Balance of trade = Exports – Imports = $122.9 billion – $192.4 billion = –$69.5 billion. 2. Suppose a country has total GDP (Y) = $10 trillion, consumption = $7 trillion, government spending = $2 trillion, investment = $2 trillion, and taxes = $1.5 trillion. What is the level of net exports or balance of trade? What is the level of public savings? What is the level of private savings? What is the level of net capital outflow? [LO 18.1, 18.3] Answer: a. Net exports: Y = C + I + G + NX, so 10 = 7 + 2 + 2 + NX. Thus, NX = 10 – 7 – 2 – 2 = –$1 trillion. b. Public savings = T – G = 1.5 – 2 = –$0.5 trillion. c. Private savings = Y – C – T = 10 – 7 – 1.5 = $1.5 trillion. d. Net capital outflow = NX = –$1 trillion. Net capital outflow = Total savings – I = (Public savings + Private savings) – I = –0.5 + 1.5 – 2 = –$1 trillion. 3. In 2010, U.S. investors purchased $50 billion in foreign assets, and foreigners purchased $100 billion in U.S. Page 953assets such as stocks and Treasury bills. In addition, U.S. businesses invested $150 billion in foreign factories and operations, while foreign companies invested $100 billion in U.S. factories and operations. What was the net capital outflow for the United States? [LO 18.2] Answer: Total U.S. foreign investment = $50 billion (portfolio investment) + $150 billion (direct investment) = $200 billion. Total foreign investment in U.S. = $100 billion (portfolio investment) + $100 billion (direct investment) = $200 billion. Net capital outflow = Total U.S. investment abroad – Total foreign investment in U.S. = $200 billion – $200 billion = $0. 4. Define each of the following as direct or portfolio foreign investment. [LO 18.2] a. Nike (a U.S. company) builds new factories in Cambodia. b. A U.S. hedge fund purchases 30 percent of the shares of a Brazilian paper manufacturer. c. Mercedes-Benz (a German company) builds a new manufacturing plant in Alabama. d. Intel (a U.S. company) sets up a new call center in India. e. A British chocolate maker buys a smaller U.S. rival. f. Hilton Hotels (a U.S. company) builds a new resort in Hawaii. Answer: a. This is direct investment since Nike is building a new factory. b. This is portfolio investment since the hedge fund is buying financial assets. c. This is direct investment on the part of Germany into the United States. d. This is direct investment since Intel is building physical capital in a foreign country. e. This is portfolio investment since the British firm is only buying existing assets and not building anything new. f. This is not foreign investment of any type since Hawaii is part of the United States. If, instead, Hilton was building a new resort in, say, Cabo St. Lucas, Mexico, this would be direct investment. 5. Tom is stuck with his friends on an island that uses coconuts for currency, but they recently discovered Wilson’s Island nearby. Tom’s Island agrees to make only one transaction with Wilson’s Island: It sells a fishing boat to Wilson’s for 15 coconuts. Answer the following questions, assuming that yearly consumption on Tom’s Island equals 500 coconuts and domestic investments in huts and farm equipment equals 150 coconuts. [LO 18.3] a. What are net exports for Tom’s Island? b. What is the total national savings for Tom’s Island? c. Suppose Tom’s Island imports a volleyball net from Wilson’s Island for 5 coconuts. What is the total national savings now? d. Now Tom purchases 1 coconut tree on Wilson Island at a cost of 10 coconuts. What is the balance of payments? (Hint: A coconut tree produces coconuts like a factory produces goods.) Answer: a. Net exports = Exports – Imports = 15 – 0 = 15 coconuts. b. Net capital outflow = Total savings – I, and Net exports = Net capital outflow, so 15 = Total savings – 150, so total savings = 165 coconuts. c. Net exports = Exports – Imports = 15 – 5 = 10. Net capital outflow = Total savings – I, and Net exports = Net capital outflow, so 10 = Total savings – 150, so total savings = 160 coconuts. d. Balance of payments = Net exports = Net capital outflows. Net exports = 15 – 5 = 10. Net capital outflow = 10 coconuts (the cost of the foreign investment into Wilson’s - note the purchase of the tree is like a foreign investment because it will return coconuts each year). 6. Over the last five years, Portlandia’s average income has risen and caused the supply curve of loanable funds to increase and shift right. [LO 18.4, 18.5] a. Would the domestic interest rate have increased or decreased? b. Given the change in the interest rate, would General Motors (GM) be more or less likely to open a Camaro plant in the country? c. If Portlandia hits a recession and interest rates fall, which way must the demand curve for loanable funds have shifted? Answer: a. The savings curve will have shifted to the right, lowering interest rates. b. At the lower interest rate, firms are more likely to engage in investment spending, such as building a new Camaro plant. This can be seen on the graph as an increase in the equilibrium quantity of funds demanded (a downward movement along the I + NCO curve). c. Assuming the savings curve has remained constant, in order for interest rates to fall, demand must have shifted to the left. This is typical in most recessions. Firms and households hold off on making large investment decisions due to uncertainty about the future, low profits, or poor sales, so investment typically falls during recessions. The effect of recessions on the savings curve is more ambiguous. A recession reduces incomes, which should reduce savings, but recessions also cause uncertainty about the future, which may cause savers to engage in additional precautionary savings. 7. Describe what happens to the supply and/or demand curves for U.S. dollars under the following scenarios. In each scenario, does the U.S. exchange rate appreciate or depreciate, and what happens to the U.S. balance of trade? [LO 18.6, 18.7] a. A drought in Russia destroys the wheat crop, resulting in increased purchases of wheat from the US b. Bollywood movies become extremely popular in the United States, increasing demand for foreign movies. c. The U.S. government forces all government offices to purchase American-made computer products, instead of importing them. Answer: a. Because foreigners want to purchase U.S. goods, the demand for U.S. dollars increases, appreciating the dollar. Because foreigners now have an increased desire to purchase American goods at any given exchange rate, the net exports curve will shift to the right. Depending on the relative size of the two shifts, the U.S. balance of trade can either rise or fall. The appreciation of the dollar will reduce net exports and the increased desire to buy American wheat will increase net exports. b. Because Americans want to purchase foreign goods, they will get rid of U.S. dollars, increasing the supply of U.S. dollars. This shifts the supply of dollars curve to the right, depreciating the dollar. Because Americans now have an increased desire to purchase foreign goods at any given exchange rate, the net exports curve will shift to the left. Depending on the relative size of the two shifts, the U.S. balance of trade can either rise or fall. The depreciation of the dollar will increase net exports and the preference for foreign goods will decrease net exports. c. Because Americans want to purchase domestic goods, they will hold on to U.S. dollars, decreasing the supply of U.S. dollars. This shifts the supply of dollars curve to the left, appreciating the dollar. Because Americans now have an increased desire to purchase domestic goods at any given exchange rate, the net exports curve will shift to the right. Depending on the relative size of the two shifts, the U.S. balance of trade can either rise or fall. The appreciation of the dollar will reduce net exports and the preference for American goods will increase net exports. 8. Suppose there is major unrest in the labor market in the United States, making European investors nervous about investing in the United States. [LO 18.6, 18.7] a. Draw the supply and demand curves for U.S. dollars, and show the appropriate shift(s) in supply and demand for U.S. dollars associated with the labor unrest. b. Did the value of the U.S. dollar depreciate or appreciate? Answer: a. Because foreigners will not want to invest in the United States, demand for U.S. dollars decreases. This shifts the demand curve to the left. b. Because the demand curve shifted to the left, the dollar depreciated. 9. A government has been running budget deficits for many years and decides to balance its budget. Explain how each of the following are affected under a floating exchange-rate regime. [LO 18.5, 18.6, 18.7] a. The interest rate. b. The exchange rate. c. The trade balance. Answer: To balance its budget, the government must reduce spending and/or increase taxes. This will increase public saving and shift the saving curve to the right. a. The interest rate will fall because the government is borrowing less so saving is higher. b. When interest rates fall, domestic financial assets are less attractive so people may prefer to move their funds to other economies with higher interest rates. Net capital outflow will increase and the exchange rate value of the domestic currency will decrease as people reduce their demand for the local currency. c. Because the currency has depreciated, net exports will rise. 10. Suppose the new CEO for Apple Inc. decides to produce all the company’s products in the United States instead of China. [LO 18.7] a. Which way will the supply for U.S. dollars shift? b. Which way will the demand for U.S. dollars shift? c. Does the value of the U.S. dollar depreciate or appreciate? Answer: a. Because Americans want to purchase domestic goods instead of foreign goods, they will hang on to U.S. dollars, decreasing the supply of U.S. dollars. b. Because foreigners now want to purchase American goods, they will demand more U.S. dollars, increasing the demand for U.S. dollars. c. From part a, supply decreases, shifting the supply curve to the left. From part b, demand increases, shifting the demand curve to the right. Both of these shifts serve to appreciate the dollar. 11. Suppose that in the United States last season’s hot holiday gift was the iPad (which is made primarily in China), while this season’s big gift is media content for the iPad (which is made in the United States). Determine whether there will be an increase, decrease, or no change for each of the following variables compared to last year. [LO 18.6, 18.7] a. Supply and demand for dollars. b. Exchange rate between the United States and China. c. Net exports for the United States. d. Net capital outflows for the United States. Answer: a. The supply of U.S. dollars will fall as Americans hang on to dollars in order to purchase domestic iPad content instead of foreign iPad hardware. The demand for U.S. dollars will remain unchanged, as we don’t know anything about foreigners’ relative interest in the iPad hardware versus iPad content. b. The supply of U.S. dollars decreases, shifting the supply curve to the left. This results in an appreciation of the dollar. c. Because Americans now have an increased desire to purchase domestic goods at any given exchange rate, the net exports curve will shift to the right. Depending on the relative size of the shift here in part c and the shift in part b, the U.S. balance of trade or net exports can either rise or fall. d. Because net exports must equal net capital outflows, the effect on net capital outflows will be the same as the effect on net exports. As noted in part c, depending on the relative size of the shift in part c and the shift in part b, the U.S. net capital outflows can either rise or fall. 12. In March 2009 the Canadian dollar was worth $0.78 U.S. dollars. In April 2011 the Canadian dollar was worth $1.06 U.S. dollars. What effect would this increase have on the trade balance between the United States and Canada? Why? [LO 18.6] Answer: Ceteris paribus, the Canadian dollar can now purchase more American goods than it did before ($1.06 vs. $0.78), so Canadians will increase their purchases of U.S. goods. Similarly, the U.S. dollar can now purchase fewer Canadian goods than before. Since Canadian imports rise and Canadian exports fall, the Canadian trade balance falls and the U.S. trade balance rises. 13. Martha has $10,000 to invest in the foreign exchange market. She’s interested in trading U.S. dollars (USD) for euros (EUR) and Japanese yen (JPY). Using Table 18P-1, determine the arbitrage profit/loss Martha will make in each of the following scenarios. (Note: Any value less than $10 should be considered zero.) [LO 18.6] a. USD EUR JPY USD. b. USD JPY EUR USD. c. Now look up the current exchange rates among any three currencies. Show that there are no arbitrage opportunities for the three currencies you chose. Answer: a. $10,000 purchases 0.7823 × $10,000 = 7,823 euros. 7,823 euros purchases 103.796 × 7,823 = 811,996 yen. 811,996 yen purchases 0.01232 × 811,996 = $10,004. This indicates an arbitrage gain of $4, but in reality this is an artifact of a rounding error. This market essentially shows no arbitrage opportunities. b. $10,000 purchases 81.200 × $10,000 = 812,000 yen. 812,000 yen purchases 0.00963 × 812,000 = 7,820 euros. 7,820 euros purchases 1.2783 × 7,820 = $9,996. This indicates an arbitrage loss of $4, but in reality this is an artifact of a rounding error. This market essentially shows no arbitrage opportunities. c. Obviously, the exact answer here will depend on the student’s choices. Typing “exchange rates” into Google will bring up current exchange rates for almost any pair of currencies. Aside from rounding error, the student will not be able to find any significant arbitrage opportunities. 14. Some politicians argue for imposing trade restrictions in the hope that doing so will reduce the trade deficit of the United States. Assuming the United States has a floating exchange rate, answer the following questions regarding the impact of the trade restrictions. [LO 18.7] a. What is the impact in the foreign exchange market for dollars? b. What is the impact in the market for foreign currency (euros, yen, etc.)? c. What happens to the exchange rate of the dollar? d. What happens to net exports? Answer: The imposition of trade barriers decreases the supply of dollars, as people in the U.S. need more dollars and less foreign currency because they will be purchasing more domestic goods. The supply of dollars curve shifts left, causing an appreciation of the exchange rate. The demand for foreign currency will decrease because fewer goods are imported and the value of the foreign currency will become weaker. Because Americans are now importing fewer goods, the net export curve shifts right and this causes net exports to rise. However, given the dollar has appreciated in value, this will reduce net exports all else the same. Depending on the relative size of the two effects, the quantity of net exports could either rise or fall. 15. Suppose the U.S. economy slips into a recession. In response, the Federal Reserve cuts the federal funds rate in order to avoid unemployment. Consider what happens to the following under a floating exchange-rate regime. [LO 18.8] a. Domestic investment. b. Capital inflow. c. Capital outflow. d. Exchange rate. e. Net exports. f. Aggregate demand. Answer: a. Domestic investment will rise since more companies would be willing to build new factories or stores with the lower interest rates. b. Capital inflow will decrease since the return to investment in the U.S. is now lower, leading foreigners to move financial assets out of the U.S. This decreases the demand for U.S. dollars. c. Capital outflow will increase since the return to investment in the U.S. is now lower, leading Americans to move their financial assets abroad. This increases the supply of U.S. dollars. d. Since the demand for U.S. dollars decreases and the supply of U.S. dollars increases, the exchange rate falls. e. Since the dollar depreciates, U.S. exports will be more competitive and domestic goods will be more competitive against imports. Net exports rise. f. Net exports are one of the components of aggregate demand. Since net exports rise, aggregate demand will also rise. 16. Reevaluate the previous problem assuming the U.S. economy follows a fixed exchange-rate regime. [LO 18.8, 18.9] Answer: The answer for all of the parts is “there is no effect.” The reason for this is that when the Federal Reserve cuts interest rates by selling bonds, this causes capital outflows to increase and capital inflows to fall, putting downward pressure on the exchange rate. In order to prop up the exchange rate to its fixed level, the Federal Reserve will have to buy bonds and increase the interest rate. Thus, the interest rate ends up back where it started, and there is no change in any of the economic variables.. 17. A country that has been operating under a fixed exchange-rate regime falls into recession. All attempts at using fiscal policy to lift the economy out of recession have failed. [LO 18.9] a. Can monetary policy be effective in this case? Why or why not? b. Should the country allow the exchange rate to float? Why or why not? Answer: If the central bank was to use monetary policy to help lift the economy out of the recession, it would want to increase the money supply and decrease interest rates in the economy. This change in interest rates would cause an increase in net capital outflow as people seek higher rates of return elsewhere. The value of the domestic currency would decrease as people increase the supply of domestic currency. To maintain the fixed exchange rate, the central bank would have to buy domestic currency. Under a fixed exchange-rate regime, the central bank cannot use monetary policy to influence economic activity because it needs to buy/sell domestic currency to maintain the fixed exchange rate. The central bank needs to decide which goal is more important—the fixed exchange rate or the state of the domestic economy. 18. In Windsor, Ontario, a Big Mac from McDonald’s costs C$4.16 (Canadian dollars), and across the border in Detroit it costs $3.54 in U.S. dollars. [LO 18.10] a. Suppose the nominal U.S. exchange rate with Canada is US$0.80 per Canadian dollar. Does the purchasing power parity hold between the two countries? b. What is the purchasing power parity exchange rate for the United States? Answer: a. Purchasing power parity between the two countries does not hold. If purchasing power parity holds, a Big Mac should cost the same in each country after accounting for the exchange rate. But if the exchange rate is $0.80 (US/C), the Canadian Big Mac costs C$4.16 × 0.80 (US/C) = US$3.33 in Canada, which is less than the $3.54 actual cost of the Big Mac in the U.S. b. If purchasing power parity holds, a Big Mac should cost the same in each country after accounting for the exchange rate. So, we need to find EX (expressed in terms of $ per C$) such that EX × C$4.16 = $3.54. Dividing both sides by C$4.16 gives us EX = 0.851 dollar per Canadian dollar. 19. Suppose the current U.S.−UK exchange rate is 0.63 pound (the pound is the UK currency) per dollar, and the aggregate price level is 170 for the United States and 140 for the UK. What is the real exchange rate? What does this real exchange rate mean in terms of the relative purchasing power of the dollar and the pound? [LO 18.10] Answer: The real exchange rate = nominal exchange rate × (domestic price level/foreign price level), so real exchange rate = 0.63 × (170/140) = 0.765. This real exchange rate means that the U.S. dollar buys 0.765 times as much “stuff” in the UK as it would in the U.S. 20. Imagine there are only two trading nations in the world. For each of the following scenarios, determine whether goods in one country will become more attractive relative to goods in the other country given their inflation rates and a shift in the nominal exchange rates. [LO 18.10] a. Inflation is 8 percent in the UK and 4 percent in Germany, but the UK pound−euro exchange rate remains the same. b. Inflation is 3 percent in the U.S. and 7 percent in Japan, but the exchange rate for the United States. dollars to Japanese yen increases from 70 to 80 Japanese yen. c. Inflation is 10 percent in the United States. and 6 percent in Mexico, and the price of the Mexican peso rises from US$0.08 to US$0.15. Answer: a. Because prices are going up faster in the UK than in Germany but the German currency is not appreciating, German goods will become relatively cheaper in the UK and British goods will become relatively more expensive in Germany. b. Due to inflation, the nominal costs of goods made in Japan are becoming more costly compared to those made in the U.S. at a rate of 4 percent = 7 percent (Japanese inflation) – 3 percent (U.S. inflation). The Japanese currency is becoming cheaper, however, at a rate of 14 percent = (70 – 80)/70. Thus, Japanese goods will become relatively cheaper compared to U.S. goods. Using an example, imagine a good that currently costs $1.00 in the U.S. and 70 yen in Japan. At an exchange rate of 70 yen/$, the two goods are the same price in each country. Now assume inflation of 3 percent and 7 percent, respectively. The U.S. item now costs $1.03 ($1.00 × 1.03) and the Japanese item now costs 74.9 yen (70 yen × 1.07). When converted to U.S. dollars using the new exchange rate of 80 yen per dollar, the Japanese item costs 74.9 yen/80 = $0.936, so it has become cheaper. c. In this case, due to inflation, the nominal costs of goods made in the U.S. are becoming more costly compared to those made in Mexico at a rate of 4 percent = 10 percent (U.S. inflation) – 6 percent (Mexican inflation). The Mexican currency is becoming more expensive, however, at a rate of 88 percent = (0.15 – 0.08)/0.08. Thus, U.S. goods will become relatively cheaper compared to Mexican goods. Using an example, imagine a good that currently costs $1.00 in the U.S. and 12.5 pesos in Mexico. At an exchange rate of 0.08 pesos/$, the two goods are the same price in each country. Now assume inflation of 10 percent and 6 percent, respectively. The U.S. item now costs $1.10 ($1.00 × 1.10) and the Mexican item now costs 13.25 pesos (12.5 pesos × 1.06). When converted to U.S. dollars using the new exchange rate of 0.15 dollar per peso, the Mexican item costs 13.25 × 0.15 = $1.9875, so it has become more expensive. 21. Over several years, foreign investors poured billions of dollars into a country due to its favorable growth prospects. They have now become concerned about the return on their investments because growth in the country is stagnating. As a result they are pulling their money out. Will this country be better able to withstand the financial crisis if it has a fixed or a floating exchange rate? Explain. [LO 18.11] Answer: Under a floating exchange-rate system, the country's currency will depreciate and interest rates in the country will increase. As a result of these changes, net exports will increase and consumption and investment spending will decrease. Under a fixed exchange-rate system, the country's currency will not change in value and interest rates in the country will not change because the central bank will need to buy domestic currency and sell foreign currency to maintain the fixed exchange rate. As a result of these changes, net exports will not change and consumption and investment spending will not change. Under the floating exchange-rate system, the value of GDP is likely to decrease due to higher interest rates unless the change in net exports is significant. Under a fixed exchangerate regime, the central bank may exhaust its supply of foreign currency because it must buy domestic currency in exchange for foreign currency demanded by people as they pull their funds out of the country. CHAPTER 19 DEVELOPMENT ECONOMICS Chapter Overview Although the work needed to put an end to global poverty may seem daunting, major strides have been made and continue to be made. Most obviously, decades of growth in the Chinese economy have lifted millions of people out of poverty. What worked for China was the product of a time and place that can’t simply be bottled and shipped to other regions. Yet there are hopeful signs of improvements elsewhere, including Africa. Around the African continent, vigorously contested, democratic elections are taking place, and some countries are posting impressive growth figures. Progress is being made through different mixes of good governance, aid, strengthened institutions, investment, and careful testing of what works and what does not among aid programs. While there is a long way to go, progress like this can promote the expansion of capabilities and help expand markets that truly work for the world’s poor. Learning Objectives LO 19.1 Explain how the capabilities approach relates to economic development. LO 19.2 Explain the relationship between economic growth and economic development. LO 19.3 Describe how improvements to education and health can develop human capital. LO 19.4 Explain the importance of institutions and good governance in development economics. LO 19.5 Evaluate the role of industrial policy and clusters in development. LO 19.6 Evaluate how migration and remittances promote development. LO 19.7 Describe the aims of foreign aid, the role of poverty traps, the main institutions delivering aid, and criticisms of foreign aid. LO 19.8 Understand how impact investing provides a new tool for creating social impact. LO 19.9 Explain the need for impact evaluation and analyze the role of randomized controlled trials in measuring impact. Chapter Outline POVERTY AMID PLENTY Development and Capabilities The Capabilities Approach (LO 19.1) BOX FEATURE: WHAT DO YOU THINK? – UTILITY VERSUS CAPABILITIES Economic Growth and Economic Development (LO 19.2) The Basics of Development Economics Human Capital (LO 19.3) BOX FEATURE: REAL LIFE – USING LENTILS TO FIGHT DIPHTHERIA Institutions and Good Governance (LO 19.4) BOX FEATURE: FROM ANOTHER ANGLE – BUILDING CITIES FROM SCRATCH Investment (LO 19.5) Trade Migration (LO 19.6) BOX FEATURE: REAL LIFE – SENDING HOME THE RICHES BOX FEATURE: FROM ANOTHER ANGLE – TRILLION-DOLLAR BILLS ON THE SIDEWALK? What Can Aid Do? Perspectives on Foreign Aid (LO 19.7) BOX FEATURE: WHAT DO YOU THINK? – SHOULD THE UNITES STATES GIVE MORE IN FOREIGN AID? BOX FEATURE: FROM ANOTHER ANGLE – IN ZAMBIA, DID THE STEELERS WIN SUPER BOWL XLV? Impact Investing (LO 19.8) How Do We Know What Works? (LO 19.9) Beyond the Lecture Class Discussion: Economic Growth and Economic Development (LO 19.2) Have students examine Human Development Index indicators for different countries and ask them to consider the relationship between economic growth and the human development index. Discuss the following: 1. How can economic growth improve factors included in the human development index? 2. What other factors are important? Class Discussion: Institutions (LO 19.4) Have students watch this brief clip from the TV show The Colbert Report, in which Colbert interviews Dambisa Moyo, the author of Dead Aid: Why Aid is Not Working and How There is a Better Way for Africa. Discuss the following: 1. How are rules and governance important to economic development and growth? 2. How can international aid assist countries with economic development? Can international aid also cause problems? 3. What can be done to assist developing countries? Class Discussion: Problems with Foreign Aid (LO 19.7) Have students watch this brief clip from John Stossel regarding the pros and cons of foreign aid. The clip primarily highlights problems with government foreign aid, but it is a good starting point for conversation. Discuss the following: 1. What are the pros and cons of the use of foreign aid in development? 2. Are there any ways to assist individuals in developing countries and avoid some of the potential problems associated with foreign aid between governments? 3. What do you think about foreign aid? Class Discussion: Economic Growth and Economic Development (LO 19.2) Have students examine Human Development Index indicators for different countries and ask them to consider the relationship between economic growth and the human development index. Discuss the following: 1. How can economic growth improve factors included in the human development index? 2. What other factors are important? Class Media: Economic Growth (LO 19.2) Have students watch the following video by Hans Rosling. 1. What happened to the wealth and health of countries over time? 2. What effects did the Industrial Revolution and World Wars have on wealth, health, and life expectancy. 3. Does this video disprove the convergence model? (Hint: the answer is no. While the west is far above many others, all countries are healthier and wealthier than 100 years ago, and the poorest countries are catching up). Class Media: Institutions (LO 19.4) Have students watch this brief clip from the TV show The Colbert Report, in which Colbert interviews Dambisa Moyo, the author of Dead Aid: Why Aid is Not Working and How There is a Better Way for Africa. Discuss the following: 1. How are rules and governance important to economic development and growth? 2. How can international aid assist countries with economic development? Can international aid also cause problems? 3. What can be done to assist developing countries? Class Discussion: Problems with Foreign Aid (LO 19.7) Have students watch this brief clip from John Stossel regarding the pros and cons of foreign aid. The clip primarily highlights problems with government foreign aid, but it is a good starting point for conversation. Discuss the following: 1. What are the pros and cons of the use of foreign aid in development? 2. Are there any ways to assist individuals in developing countries and avoid some of the potential problems associated with foreign aid between governments? 3. What do you think about foreign aid? Clicker Questions There are three main purposes to clicker questions. First, they are a great way to do a quick and instant “on demand” test of student understanding of the material. You can cover material, and instantly get feedback on student comprehension. You can see whether you need to explain certain topics again, or move on to the next subject. Second, they are a great method to break up the class and take a moment away from lecture. It gets the students actively involved. Finally, certain clicker questions can be framed in a “discussion” manner, in which you can invite students to talk about the possible right answer with their peers. You can instruct students to convince their classmate of a right or wrong answer. 1. In the opinion of many economists, which of the following institutions is necessary for a country to create sustained long term growth? [LO 19.1, 19.4] A. Extremely high environmental standards B. Property rights and profit incentives C. Government which controls market prices D. Capability to produce all necessary goods for the country without relying on trade Feedback: You have to give people a reason to work hard, start businesses, and produce things that are in demand. When people can own a business, incentives to create a business exist. With rule of law and property rights, there are fewer incentives to begin or grow a business, and this can slow down economic growth. 2. How can international trade help a country grow? [LO 19.2] A. They can find cheaper goods and also sell their own goods to new buyers B. Foreign countries will begin giving charity C. Other countries will generally want to build their factories in developing countries D. There is a very fast equalization of advanced technology across trading countries Feedback: We can use comparative advantage! We can get stuff from others cheaper, or we can sell our own stuff to them if they can’t make it themselves. We are helped on the consumption and production side. 3. What are remittances? [LO 19.6] A. When a foreigner enters the USA illegally B. When an American firm opens a factory in a foreign country C. When an emigrant takes money earned in the USA and sends the money back to his country D. Tax breaks given to emigrants to work full time Feedback: They are a large financial flow in some poor developing countries. 4. Why do some economists argue that foreign aid can be counterproductive and even harmful to the country receiving it? [LO 19.7] A. Aid may not go to the intended recipients B. It can crowd out domestic investment in the country C. It can hurt exports from the country by increasing the value of the local currency D. All of the above Feedback: Some have even further argued that it can simply make the country “dependent” on aid rather than improving their own government, institutions, education, and capital stock. 5. Why might private investment be more beneficial in developing countries compared to foreign aid provided by governments? [LO 19.7, 19.8] A. Individuals send money to richer countries B. A stronger incentive to make sure the investment is put toward a more concrete goal C. Private individuals can negotiate better exchange rates D. Private individuals can usually provide more money than the government Feedback: The government may not have much of an incentive to make sure the money for aid is going to a good purpose or being spend efficiently. An individual who is looking for a return on investment has a stronger incentive to provide oversight of the funding he provides. Solutions to End-of-Chapter Questions and Problems Review Questions 1. Are capabilities and utility the same thing? If so, why do economists use two different terms for the same concept? If not, explain the difference, both in terms of their definitions and when each is best used in economic analysis. [LO 35.1] Answer: No, capabilities and utility are not the same thing. Utility is satisfaction; in previous chapters, we’ve discussed how individuals seek to maximize utility subject to the constraint of their scarce resources (income). Capabilities, on the other hand, are possibilities—what people can do. Utility is best used for analysis on an individual level, while capabilities are best used for analysis on a societal level. 2. Determine whether each of the following is true or false. [LO 35.1] a. The chance to see a musical is an example of a capability. b. The freedom to practice religion is not a capability because it is not directly related to economic development. c. Economists will make the same conclusions and recommendations using the utilitymaximization approach as they will using the capabilities approach. d. The capabilities approach works better for analyzing what’s best for society, while the utility-maximization approach works better for analyzing what’s best for an individual. Answer: a. True. This capability relates to people being able to engage with their culture. b. False. Capabilities do not have to be directly related to economic development. c. False. The capabilities approach takes a broader view. What may maximize one person’s utility may not maximize capabilities for society as a whole. d. True. The utility-maximization approach attempts to find what will give an individual as much satisfaction as possible, given constraints. The capabilities approach focuses instead on what will maximize capabilities in a broad sense for society as a whole, considering things as disparate as engagement in culture, self-expression, health, and human capital. 3. Are economic growth and economic development the same? Why or why not? [LO 35.2] Answer: Economic growth and economic development are not the same. Economic growth refers to increases in output or income (GDP), while economic development refers to increases in capabilities—what those in an economy can do, including living a relatively long and healthy life, receiving education, expressing themselves relatively freely, engaging in their culture, and so on. 4. Does economic growth lead to development? Or does the causation run the other way, with economic development leading to growth? Explain. [LO 35.2] Answer: Economic growth (increases in GDP) does not necessarily lead to economic development. A nation’s GDP can rise while capabilities—to live a long and relatively healthy life, to receive education, to engage in culture, and so on—remain unchanged or even decline. However, more evidence exists that economic development leads to economic growth. Property rights, strong institutions, and increases in human capital can increase investment and productivity, leading to increases in GDP. 5. How can health and education work together to spur economic development? What does this imply about the best way to spend aid funds with the goal of increasing educational attainment in a developing nation? [LO 35.3] Answer: Education increases human capital, which tends to increase economic development. But that leaves the question of how to increase the level of education in a given nation—do we buy books, supplement teachers’ salaries, or do something else? Some studies indicate that a more indirect approach focusing on the relationship between health and education may be a good choice. Providing medication, such as deworming pills or quinine (which fights malaria), is likely to increase overall health levels of students, which may result in fewer missed school days, a greater ability to concentrate in class, and better learning outcomes. 6. Explain how better health care in a developing nation, such as increasing the number of immunized children, can have economic effects beyond fewer sick kids. [LO 35.3] Answer: A child who has been immunized and therefore isn’t sick can attend school more frequently, be more attentive in class, and learn more, all else equal. This can increase human capital, push up productivity, and lead to more economic growth. But even children or adults who don’t receive the vaccine can benefit. More vaccinated children can lead to a positive externality—if more kids get vaccinated, not only will they not get sick, but they won’t spread illness to other children and adults. As we discussed in the chapter on externalities, because the positive effects of vaccinations extend beyond those who actually get the vaccines, this is a case where government intervention in the form of providing or subsidizing vaccines could be useful. 7. “I’m thinking about writing a paper for class on development economics,” your friend tells you over lunch. “I’m going to focus on important institutions like government bodies and economic agencies.” Is your friend using the term institutions correctly? Why or why not? [LO 35.4] Answer: No. In development economics, the term institutions refers to the rules and customs that describe what is and isn’t acceptable in a society. The government bodies and economic agencies your friend is describing are referred to as organizations in development economics. 8. How can capital be considered “dead,” and what do we mean by making this capital “alive?” [LO 35.4] Answer: Capital is considered “dead” when it doesn’t have a legally enforceable title providing proof of ownership. Such assets could be used as collateral to get loans and therefore spur economic development via investment, but without a title lenders will be unwilling to make these loans. This capital can become “alive” if property rights are wellestablished and enforced by a strong titling and court system. Although the evidence is somewhat mixed, “dead” capital contributes less to economic development than does capital that’s “alive.” 9. International trade is associated with economic growth and development—open economies tend to grow faster than closed economies, all else equal. Given this information, should a nation seeking to grow and develop faster use the method of import substitution or export-led growth? How would each of these two methods affect GDP through its net exports component? [LO 35.5] Answer: Export-led growth is accomplished by subsidizing exports and giving tax breaks to producers of goods to be sold to other nations. This will increase net exports by increasing exports (remember, net exports = exports – imports). Import substitution, on the other hand, discourages imports with methods such as tariffs. It can also increase net exports, but by decreasing imports instead of increasing exports. Though both methods can increase GDP through its net exports component, export-led growth keeps the economy more open in terms of international trade and, given what we’re told in the question, would be the better choice. 10. Determine whether each of the following is an example of import substitution, export-led growth, or clustering. [LO 19.5] a. The government gives a $50 million grant to a leading university to work with car manufacturers and to research new ways to produce more fuel-efficient vehicles. b. The government gives $50 million to a domestic car company to subsidize its shipping costs to other countries. c. The government enacts a tariff on all cars imported from abroad. Answer: a. Clustering. b. Export-led growth. c. Import substitution. 11. How can emigration help the home economy in terms of income? Are the benefits of migration on income limited to those who actually migrate? Why or why not? (LO 19.6) Answer: Emigration can boost a nation’s income when those that migrate send remittances back home. But the positive effects of migration aren’t limited to those who actually migrate. Many emigrants return home with new ideas and skills gained abroad, which can be passed on to workers in their home economy and may boost productivity and income. 12. How does emigration affect wages and income in the migrant’s country of origin? In the country the migrant immigrates to? (LO 19.6) Answer: Emigration increases wages and income in the home nation in two ways. First, having some workers leave the domestic labor market to seek work elsewhere reduces the home country’s supply of labor, pushing up wages and increasing income, all else equal. Remittances (money sent home by emigrants) increases income further. It’s a common fear that immigration will cause decreases in wages and income in the destination country. Although there is some evidence that wages may decrease for domestic low-skilled workers who can be replaced by immigrants willing to take lower pay, evidence is more mixed than many think. If immigrants take jobs that domestic workers don’t want—and there is evidence that this is frequently the case—wages for domestic workers won’t decrease, and the additional production from these immigrants can boost national income in the destination country as well. 13. Say that the United States is considering giving direct aid to a nation run by a dictator known for his lavish lifestyle while the nation’s citizens suffer through a terrible famine. What might be a problem with giving aid to this nation? Name at least one way to fix the problem. (LO 19.7) Answer: The problem with giving aid to this nation is that the dictator might simply keep the funds given, as in the case described in the text where “peacekeeping funds” in Sierra Leone were embezzled by generals to buy television sets and hunting rifles. Beyond this, there will be little incentive for the dictator to make real economic improvements because that would cause aid, and therefore his lavish lifestyle, to be reduced or eliminated entirely. Luckily, several approaches can address this problem, including monitoring the use of the donated funds and setting specific, measurable goals for economic development in the recipient nation, on the condition that if information isn’t given as requested or goals aren’t met that aid will stop. Also, efforts to improve the nation’s government, such as making receipt of funds contingent on economic and governmental changes and providing assistance in making those changes, will increase the chance of real increases in economic development in the nation over the long run. 14. What are goods-in-kind donations, and how can they hurt the economies they’re meant to help? (LO 19.7) Answer: Goods-in-kind donations are transfers of goods to nations in which we want to improve economic growth and development. They can be free donations or sold at a low price. Even with the best of intentions, goods-in-kind donations can hurt the economies we’re trying to help. Influxes of goods from other countries can hurt domestic manufacturers of those goods, and sometimes we send goods the nation doesn’t need or want. Additionally, even donated goods require shipping costs, which can be substantial and can take up funds that could be better spent in other ways. 15. How does impact investment differ from traditional foreign aid and traditional financial investment? [LO 19.8] Answer: The problem with giving aid to this nation is that the dictator might simply keep the funds given, as in the case described in the text where “peacekeeping funds” in Sierra Leone were embezzled by generals to buy television sets and hunting rifles. Beyond this, there will be little incentive for the dictator to make real economic improvements because that would cause aid, and therefore his lavish lifestyle, to be reduced or eliminated entirely. Luckily, several approaches can address this problem, including monitoring the use of the donated funds and setting specific, measurable goals for economic development in the recipient nation, on the condition that if information isn’t given as requested or goals aren’t met that aid will stop. Also, efforts to improve the nation’s government, such as making receipt of funds contingent on economic and governmental changes and providing assistance in making those changes, will increase the chance of real increases in economic development in the nation over the long run. 16. Explain briefly how you could set up an RCT to evaluate whether providing free breakfasts to elementary-school students helps them learn. (LO 19.9) Answer: One initial consideration would be how to define and evaluate “learning” in this case. If you decide to use written tests, you’ll want to be reasonably sure test results are correlated with learning in some meaningful way. Then you’d want to create two groups matched in important factors—demographics, family income, school attendance, hours spent studying, previous grades and test results, and so forth—and randomly assign equal numbers of students to each group. You’ll provide free breakfast to the treatment group and not provide it to the control group. Remember that random placement of students in either group is key to the success of an RCT. Finally, administer and score the tests, then compare the results across the two groups. If you find that the group receiving free breakfast receives higher scores, this isn’t a perfect indicator that the provision of breakfast leads to better learning, but it does lend significant support to the conclusion that it does. 17. List three shortcomings of using an RCT to evaluate the success of a given economic program. (LO 19.9) Answer: There are several possible answers, but these come from the text: (1) You may not be able to replicate the findings in other nations with different cultures and institutions. (2) An RCT is not appropriate to assess the effectiveness of all types of policies, such as a change in monetary policy. (3) An RCT doesn’t give information on why some programs are successful and others aren’t, even if it gives a good indication of whether a program is successful or not. Problems and Applications 1. In a small town in the midwestern United States lives a drug dealer and manufacturer who supplies the illegal, addictive drug crystal meth. The drug dealer insists that making and selling the drug is what gives him the most satisfaction among any possible use of his time and resources. Using the utility-maximization approach, should he be allowed to continue supplying the drug? What about with the capabilities approach? Explain your answer. [LO 19.1] Answer: The utility-maximization approach would indicate that if this activity truly gives the drug dealer the most satisfaction among all other alternatives, he should do it. But the capabilities approach looks beyond the dealer to what’s good for the society around him. Because drug addiction is correlated with increases in violent crime, theft of property, negative effects on children, restriction of freedom if users are arrested and serve jail time, and other things that hurt the capabilities of the larger society, the capabilities approach would come to the opposite conclusion. 2. Professor Bucks and Professor Liber are having a debate about the role of economic growth in contributing to economic development. Professor Bucks contends that economic growth is the only thing to consider in development, as people’s utility is directly related to their income. Professor Liber agrees that income is directly related to development, but says that there are other things to consider. Given what we’ve learned in this chapter, pick the option that is most correct according to the capabilities approach. [LO 19.1] a. Professor Bucks is correct because increases in income are the only way to measure economic development. b. Professor Bucks is correct because capabilities always increase when income does. c. Professor Liber is correct because income is unrelated to capabilities, which are the most important factor in development. d. Professor Liber is correct because income is related to development, but it is not the only contributor to capabilities. Answer: d. Professor Liber is correct because income is related to development, but it is not the only contributor to capabilities. While income and development are positively correlated, we must consider many other factors that contribute to a society’s capabilities. 3. Table 19P-1 shows the levels and annual growth rates of economic indicators for two countries, Nationavia and Countrystan. Assume these growth rates will remain constant for the foresee-able future. Use these data to determine whether each of the following statements is true, false, or indeterminable. [LO 19.2] a. The theory of income convergence (that national incomes in poor countries will “catch up” to those in wealthier countries) holds for Nationavia and Countrystan. b. Countrystan has higher levels of human capital than Nationavia. c. Inequality is greater in Nationavia. d. In 10 years, it’s likely that Countrystan will have higher levels of human capital than Nationavia. Answer: a. False. For the incomes in the two nations to converge, the wealthier nation (Nationavia, with its GDP per capita of $50,000) should experience relatively slower growth in income, and the poorer nation (Countrystan, with its GDP per capita of $30,000) should experience relatively faster growth in income to catch up. But Countrystan’s growth rate of GDP per capita is 3.0%, which is less than Nationavia’s growth rate of 3.1%. b. False. We can assess human capital by looking at average years of education per person. In Countrystan, that’s 5 years, while in Nationavia it’s 15 years. With the data we have, there is no indicator that Countrystan has higher levels of human capital than does Nationavia—in fact, the opposite is implied. c. Indeterminable. We have information on GDP per capita, which gives us an idea of how much income the “average” person in each nation has, but there is no information about how that income is actually distributed. d. False. Education per person is growing in Countrystan at a rate of 8 percent and is currently at 5 years, compared to Nationavia’s 15 years. To have higher levels of human capital in 10 years, Countrystan’s education per capita would have to more than triple to exceed Nationavia’s 15 years over that time period. An easy way to see why this is not likely is to use the Rule of 70, which tells us the time it takes for some variable to double (in this case, for Countrystan’s 5 years of education per capita to double to 10 years of education per capita). We take 70 divided by the growth rate in percentage form: 70/8 = 8.75. Since it would take 8.75 years at this growth rate for Countrystan’s education per capita to double to 10 years, reaching 15 years in a decade is impossible if the growth rate doesn’t change. 4. In Nation A, GDP per capita is $21,000 and is growing annually at a rate of 1.4 percent. The average citizen in Nation A lives for 51 years, and this figure is growing at 6 percent per year. Additionally, the average person in Nation A has 9 years of education, growing annually at 5.1 percent, and 60 percent of Nation A’s population is currently literate, growing at a rate of 2 percent. In Nation B, GDP per capita is $40,000 and is growing annually at a rate of 0.8 percent. The average citizen in Nation B lives for 68 years, and this value is growing at 2 percent per year. The average person in Nation B has 10.5 years of education, increasing 2 percent annually, while 78 percent of its population is literate, a figure growing at 0.5 percent annually. Which nation is experiencing more economic growth? Which is wealthier? Which currently has more capabilities for its citizens? And which is experiencing more economic development? [LO 19.2] Answer: Nation A is experiencing more economic growth because the growth rate of its GDP per capita of 1.4% exceeds that of Nation B (0.8%). Nation B is wealthier, with GDP per capita of $40,000 versus Nation A’s GDP per capita of $21,000, which may provide evidence of convergence since the lower-income nation is experiencing faster growth than the higher-income nation, which may allow it to “catch up.” Nation B has more capabilities—its citizens on average are likely to have more education, a longer lifespan, and are more literate. We find this by looking at the average levels of each of these variables. But to find which nation is experiencing more economic development, we turn our attention to growth rates in these variables. Nation B also has more economic wealth overall as reflected in the higher level of GDP per capita. But Nation A is experiencing more economic development or growth, as its growth rates for literacy, education, and life expectancy are higher than those for Nation B. In other words, Nation B is more developed, while Nation A is developing more. 5. Imagine that you are the leader of a low-income nation. You have identified lack of access to health care as a major contributor to your nation’s low income, and the United States has offered to help by providing funds to build more health clinics. Will this solve the problem? Why or why not? If it won’t, what’s one alternative to using these foreign aid dollars to build clinics? [LO 19.3] Answer: Building health clinics will not necessarily solve the problem. Home remedies and untrained non-medical professionals may continue to be more appealing to your citizens because they’re cheaper than clinics and because the non-medical professionals may spend more time with or act more concerned about their patients. This last portion may be especially true because many times doctors in health clinics have too many patients and receive the same salary no matter how many they treat or what quality of care they give. A better use for these funds might be to provide national health insurance so that citizens can seek care at a variety of medical facilities for no or low cost. It is harder to address the issue of the quality of providers in medical clinics, but one possibility might involve attaching providers’ compensation to quality reviews, time spent with the patient, or some other measure, as opposed to paying them a flat salary. 6. While listening to the radio on the way to school, you hear a politician from a small, lowincome nation say the following: “Over the last five years, there has been a 10 percent increase in the number of children attending school full time. We can expect to see these children grow up to be more productive workers because their human capital has increased.” Is the politician’s statement true, false, or somewhere in between? Explain your answer. [LO 19.3] Answer: The statement is somewhere in between true and false. It’s true that more children in his nation are attending school, and years of schooling do contribute to human capital, but that’s not the whole story. Having more years of education means little if that education doesn’t result in better learning outcomes—increased literacy, better math skills, and so on. And if this increase in student attendance hasn’t been accompanied by increases in necessary factors like classroom space, textbooks, and teachers to accommodate these new students, more education may not mean more learning or more productive workers. The quantity of education has increased in this nation, but we know nothing about its quality. 7. Classify each of the following as an institution or organization. [LO 19.4] a. The United States Agency for International Development, a U.S. government agency that channels aid abroad. b. The United Nations Development Program. c. The UN Declaration of Human Rights, an agreement among members of the United Nations regarding the rights of individuals. d. The United Nations. e. The Sarbanes-Oxley Act (SOX), which established rules for how publicly traded firms must report information in their financial documents. Answer: Institutions are the humanly devised constraints that shape human interactions, also thought of as the rules of the game. Organizations are government bodies (such as senates and ministries of education), development agencies (such as the World Bank), and international groups (such as the United Nations). a. Organization b. Organization. c. Institution. d. Organization. e. Institution. 8. A given nation has a good titling system, but theft of productive equipment is rampant, with few consequences for those who steal. What is the term development economists use for what’s lacking in this economy? What effect will this lack likely have on economic growth and economic development? Give one way to improve the situation. [LO 19.4] Answer: The nation doesn’t have strong rule of law if people can steal productive assets and go unpunished or under-punished. A nation without strong rule of law will experience slower economic growth and development, all else equal. Titling doesn’t contribute to growth and development if, even if you can show you legally own something, no one will defend your right to keep it and use it. There are many possible ways to improve the situation, including more or better police, less political corruption, and a better legal system. 9. The small, landlocked nation of Wheatleyton is just starting to develop an agricultural sector. Firms in this sector appeal to the government to temporarily limit imports of agricultural goods from other nations with more experience and larger scale, resulting in import prices so low domestic firms can’t compete. What is this desired policy called? What problems are associated with it, and how can we reduce them? [LO 19.5] Answer: Firms in the infant industry are requesting a policy of import substitution. Import substitution is associated with problems such as rent-seeking behavior that attempts to get politicians to keep competition away. It’s also likely to be extended long past its original temporary status; after all, protected firms are likely to lobby to keep these benefits. Perhaps the best way to reduce these problems is not to use import substitution at all, instead utilizing a program of export-led growth, which will provide tax breaks and subsidies on exports instead of limiting imports. 10. The small nation of Movieheim wants to develop a film industry. It is considering two options for doing so: Option A: Reimburse relocation expenses for firms and give tax breaks to acting schools, film studios, digital artists, etc., to encourage them to work together and share ideas. Option B: Make the purchase and exhibition of foreign films illegal for the next 10 years. What would development economists call each of these options? Which is more likely to encourage long-term economic development, and why? [LO 19.5] Answer: Option A is describing a cluster; Option B is describing import substitution. The first option is more likely to encourage long-term economic development because having related firms located close to each other and offering tax breaks to those firms to encourage collaboration tends to make the industry stronger. The second option of import substitution limits capabilities. Though the government intends to have the program last for only ten years, such programs tend to get extended via heavy lobbying by the protected firms, as these firms engage in rent-seeking behavior. For these reasons, Option A is the better choice, all else equal. 11. Consider separately each of the following hypothetical scenarios about South Africa and answer the included questions. Assume in each case that medical school has an 80 percent success rate—in other words, 80 percent of people who attend medical school graduate and become doctors. [LO 19.6] a. No doctors are allowed to emigrate, and the number of people going to medical school is given by D = 100,000 x I, where I is an index relating the income of doctors to those in other professions. If I = 4, how many students will go to medical school? How many more doctors will there be in South Africa? b. The United States decides to offer visas for any doctors from South Africa. Additionally, I in the above equation changes to 10. Assume that 30 percent of doctors educated in South Africa immigrate to the United States. How many students will go to medical school? How many will become doctors? How many of those doctors will practice in South Africa, and how many will practice in the United States? c. The United States decides to limit the number of doctors from South Africa who can obtain visas to no more than 10 percent of those graduating from medical school. Assume that I remains at 10. How many students will go to medical school? How many will become doctors? How many of those doctors will practice in South Africa, and how many will practice in the United States? Answer: a. Here I = 4, so the number of students going to medical school will be D = 100,000 x 4 = 400,000. Of those, 80% will graduate, so there will be a total of 0.8 x 400,000 = 320,000 new doctors. b. Now I = 10, so the number of students going to medical school will be D = 100,000 x 10 = 1,000,000. Of those, 80% will graduate, so there will be a total of 0.8 x 1,000,000 = 800,000 new doctors. 30 percent of these (0.3 x 800,000 = 240,000) will immigrate and practice in the United States, and the remaining 70 percent (0.7 x 800,000 = 560,000, or 800,000 – 240,000 = 560,000) will practice in South Africa. c. I remains at 10, so 1,000,000 will attend medical school and 800,000 new doctors will be created, as in part (b). 10 percent of these (0.1 x 800,000 = 80,000) will immigrate and practice in the United States, and the remaining 90 percent (0.9 x 800,000 = 720,000, or 800,000 – 80,000 = 720,000) will practice in South Africa. 12. Table 19P-2 shows the size of various flows to developing countries in 2009 and 2010 in billions of dollars. [LO 19.7] a. Rank each of the flows in 2010 as a percentage of ODA (official development assistance) in 2009, from highest to lowest. b. Rank each of the flows in terms of their growth rates from 2009 to 2010, from highest to lowest. Answer: a. We can calculate these figures with the following equation: 2010 2009 = × 100 2009 Financial Flow Percentage of 2009 ODA Rank (1 = highest) Official development assistance 119/128 x 100 = 92.97% 3 Foreign direct investment 573/128 x 100 = 447.66% 1 Remittances 324/128 x 100 = 253.13% 2 b. We’ll calculate the growth rate for a given flow using a simple percentage change formula: 2010 − 2009 ℎ = × 100 2009 Financial flow Growth rate Rank (1 = highest) Official development assistance [(119 – 128)/128] × 100 = – 7.03% 3 Financial flow Growth rate Rank (1 = highest) Foreign direct investment [(573 – 510)/510] × 100 = 12.35% 1 Remittances [(324 – 307)/307] × 100 = 5.54% 2 13. The following equation provides an alternative calculation to determine a developing country’s financing gap: FG = (A × g) – ID. In this equation, FG is the financing gap; A is a variable that captures the country’s starting income together with its ability to turn investment into growth (expressed in dollars); g is the targeted growth rate; and ID is the amount of domestic investment currently in the economy. Assume that A = $50,000,000,000, g = 0.08, and ID = $500,000,000, and answer the questions that follow. [LO 19.7] a. What is the size of the financing gap? b. Assume that the population of the United States is 300 million. How much would each U.S. citizen have to pay to fill the financing gap? c. What percentage of GDP per capita in the United States does your answer from (b) rep-resent if GDP per capita is currently $45,000? Now assume that the United States decides to donate the amount of the financing gap to the developing country as aid. Assume also that there are administrative and competitive costs associated with receiving aid. Specifically, 23 cents of every dollar spent on aid will go to administrative costs. Also, for every dollar received from abroad intended to be used for investment, 50 cents will be used for noninvestment purposes. d. Calculate the real increase in investment dollars the aid from the United States will provide in the recipient country. e. Calculate the new financing gap by subtracting the above from the financing gap you calculated in part (a). Answer: a. We can calculate the financing gap by plugging the given values into our formula: FG = (A × g) – ID FG = $50,000,000,000 × 0.08 - $500,000,000 = $3,500,000,000. b. To put the financing gap in per-person terms, just divide the gap by the U.S. population: $3,500,000,000 / 300,000,000 = $11.67. c. Divide the amount from part (b) above by GDP per capita, then multiply by 100 to express it as a percent: Percentage of GDP per capita = $11.67 / $45,000 × 100 = 0.026%. d. We’re told that of every $1, $0.23 + $0.50 = $0.73 doesn’t go to investment in the recipient country. That means that only 27 percent (1 – 0.73 = 0.27 = 27 percent) of the money donated will increase investment in that country. Therefore, our donation will result in only 0.27 × $3,500,000,000 = $945,000,000 more investment there. e. To find the new financing gap, subtract the value you calculated in part (d) from the original financing gap calculated in part (a): $3,500,000,000 - $945,000,000 = $2,555,000,000. 14. The president of an organization specializing in foreign investment says the following at a share-holder meeting: “Our one-year program was a failure. We were hoping for a 6 percent return on our investment, but we got only 3 percent.” Use the idea of impact investing to provide an alternative argument that the program was not a failure. [LO 19.8] Answer: In traditional financial investment, success or failure is assessed by looking at returns in a narrow sense—by this standard, the 3 percent return when the organization was hoping for 6 percent represents a failure. But impact investing takes a broader view, looking at the longer term, considering social improvements as well as financial gains, and so forth. From this point of view, the 3 percent return may be considered a success if it was accompanied by other positive social changes. 15. Table 19P-3 displays the results of a study on how to improve vaccination rates in a developing nation. The baseline numbers represent the rates of vaccination at the beginning of the study, while the endline numbers represent the rates of vaccination at the study’s conclusion. Answer the following questions. [LO 19.9] a. Which campaign(s) had a positive effect on vaccination rates in comparison to the control group? b. Which campaign had the largest positive effect on vaccination rates in comparison to the control group? c. Which campaign(s) had a negative effect on vaccination rates in comparison to the control group? d. Which campaign(s) had no effect on vaccination rates in comparison to the control group? Answer: First, calculate the change in the vaccination rate for each group for each campaign. To do so, take the endline rate minus the baseline rate. Campaign Change in vaccination rate, control group Change in vaccination rate, treatment group Lectures 8% – 5% = 3% 5% – 6% = –1% Free provision 8% – 5% = 3% 8% – 4% = 4% Subsidy 8% – 5% = 3% 10% – 5% = 5% Newspaper announcements 8% – 5% = 3% 7% – 7% = 0% a. Free provision and the subsidy had a positive effect on vaccination rates in the amount of 4% and 5%, respectively. b. The subsidy had the largest positive effect at 5%. c. Lectures had a negative effect on vaccination rates at –1%. d. Newspaper announcements had no effect on vaccination rates (a 0% change). 16. Table 19P-4 displays the results of a study on how to improve vaccination rates in a developing nation. The baseline numbers represent the rates of vaccination at the beginning of the study, and the endline numbers represent the rates of vaccination at the study’s conclusion. Rank the campaigns in order from most effective to least effective. Then refer to Table 19-P5, which shows the cost per person of each campaign. Combining information from the two tables, rank the campaigns that resulted in an increase in vaccinations from high to low in terms of cost effectiveness (based on treatment effect alone). [LO 19.9] Answer: To find out which campaigns are most effective, subtract the baseline figures from the endline figures for each group and each campaign. Campaign Change in vaccination rate, control group Change in vaccination rate, treatment group Rank (1 = most effective) Lectures 6% – 4% = 2% 9% – 6% = 3% 2 Free provision 6% – 4% = 2% 8% – 7% = 1% 3 Subsidy 6% – 4% = 2% 9% – 5% = 4% 1 Newspaper announcements 6% – 4% = 2% 2% – 3% = –1% 4 In order from most successful (biggest percentage change) to least successful, we can rank the campaigns as follows: the subsidy, lectures, free provision, and newspaper announcements. To find out which programs are most cost-effective, the quickest way is to divide the percentage change in vaccinations for the treatment group calculated in the above table by the cost per person of each campaign given in Table 19-P5 (don’t worry about converting the percentages to decimal format—for example, on the first, simply take 3 divided by 10). We leave out the newspaper announcements, since they resulted in a decrease in vaccinations. Note that the highest-ranked campaigns are those with the lowest cost per percentage gain in vaccinations. Campaign Change in vaccination rate/cost per person Rank (1 = most cost effective) Lectures 3%/$10 = $0.30 3 Free provision 1%/$20 = $0.05 1 Subsidy 4%/$15 = $0.27 2 Solution Manual for Macroeconomics Dean Karlan, Jonathan Morduch 9781259813436
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