Questions & explanations
1. How do interest rate parity and the Fisher effect together explain expected changes in exchange rates?
Interest rate parity says the expected change in exchange rate equals the interest rate difference. The Fisher effect says the interest rate difference reflects the expected inflation difference plus any real rate gap. So, if one country has higher expected inflation, its nominal interest rate rises, leading to an expected currency depreciation. For example, if India has higher inflation than the US, the Fisher effect predicts higher Indian rates, and interest rate parity then says the rupee should weaken. Together they imply that exchange rates move mainly due to differences in expected inflation. This is the basis of the international Fisher effect, which states that the expected change in exchange rate equals the inflation difference. It works as a long-run guide but can fail in the short run due to market frictions.
2. Give an example of an epistemic community that failed to influence policy and explain why.
The scientific community studying arms control and nuclear weapons has often struggled to influence policy. For example, during the 2000s, many experts agreed that the US missile defense system could cause a new arms race with Russia and China. They wrote reports and testified in Congress, but the US government continued building it anyway. The epistemic community failed because the issue was very political: many policymakers believed missile defense was necessary for national security, regardless of expert opinion. Also, the community was split—some experts supported missile defense. Without unity, their influence weakened. Another example is the community of economists warning about the risks of financial deregulation before the 2008 crisis; their advice was ignored by politicians who favored free markets.
3. What policies can help firms in developing countries upgrade within Global Production Networks?
Governments can invest in education and vocational training so workers learn skills for higher-value tasks. They can also build good roads, ports, and internet to make production easier. Offering tax breaks or subsidies for research and development encourages firms to innovate. Setting up special economic zones where firms can test new technologies helps. Another policy is to require foreign companies to train local workers or share technology. For example, some countries mandate that foreign carmakers source parts from local suppliers. This gives local firms a chance to improve and later produce more complex parts. Finally, protecting intellectual property rights can attract foreign partners who bring advanced knowledge. All these policies help firms climb the value chain and earn more.
4. How do epistemic communities influence international policy? Give an example.
Epistemic communities influence policy by sharing their expert knowledge with decision-makers. They write reports, give advice, and sometimes even help write treaties. For example, the epistemic community of economists working on international trade helped create the World Trade Organization (WTO) by advocating for free trade rules. Another strong example is the community of atmospheric scientists who pushed for the Montreal Protocol to protect the ozone layer. In the 1980s, these scientists showed that chlorofluorocarbons (CFCs) were destroying the ozone layer. They convinced governments to act, and the treaty was signed in 1987. Without their expertise, the problem might have been ignored. Epistemic communities work best when the issue is scientific and policymakers are uncertain.
5. How might a critic argue that democratic peace is not caused by democracy itself?
A critic might say that the peace between democracies is due to other factors, not democracy. For example, democracies tend to be wealthy, and wealthy countries rarely fight each other because war is bad for trade. Also, most democracies are in Europe or North America, where there is already a stable balance of power. Shared interests like NATO or the European Union keep them from fighting. Another argument is that democracies often had to fight common enemies, so they became allies. Some scholars say the 'democratic peace' is just a coincidence of the last 200 years. There are no democracies long enough in other regions to test the theory fully. Also, some near-conflicts, like India and Pakistan in 1999, involved democracies, but Pakistan was not a stable democracy at the time.
6. Compare the Specific Factors model with the Heckscher-Ohlin model in terms of factor mobility.
In the Specific Factors model, some factors are tied to one industry in the short run and cannot move. In the Heckscher-Ohlin model, all factors can move between industries over the long run. The Specific Factors model predicts that trade benefits owners of specific factors in export sectors and hurts those in import-competing sectors. The Heckscher-Ohlin model predicts that trade benefits the factor that is used intensively in the export good (the abundant factor) and hurts the scarce factor, regardless of industry. For example, a capital-abundant country benefits capital owners across all sectors. The Specific Factors model is better for short-run analysis, while Heckscher-Ohlin is for long-run after factors have adjusted. Both show that trade has distributional consequences.
7. What would happen to the price level of a developing country if its productivity in tradable goods catches up with rich countries?
If a developing country's productivity in tradable goods rises to match rich countries, wages in that sector will increase. To attract workers, the non-tradable service sector will also have to raise wages, making services more expensive. As a result, the overall price level of the country will go up. This is the Balassa-Samuelson effect in action: catching up in productivity causes the real exchange rate to appreciate. For example, as China's manufacturing productivity grew, its cost of living increased. That is why many fast-growing economies eventually see their currencies strengthen in real terms. The country's goods become more competitive, but its services become relatively more costly. This process continues until the price level reaches that of the rich countries.
8. What is the Stolper-Samuelson theorem?
The Stolper-Samuelson theorem states that a tariff (tax on imports) raises the real income of the country's scarce factor of production. For example, in a developing country with abundant low-skilled labor but scarce capital, a tariff on capital-intensive imports helps capital owners. The reason is that the tariff protects the import-competing industry, raising the price of its product. That industry uses the scarce factor intensively, so the demand and reward for that factor increase. Conversely, the abundant factor (labor) loses because the price of goods it buys goes up and its wages may fall. The theorem predicts that trade liberalization benefits the abundant factor and hurts the scarce factor. This explains why trade can increase income inequality within a country.
9. What is the Kantian triangle in international relations?
The Kantian triangle is a theory named after philosopher Immanuel Kant that says three factors work together to create peace among countries. The three factors are: democracy (republican constitutions in Kant's words), economic interdependence (trade and economic ties), and international organizations (like the UN or WTO). These three are often drawn as the three corners of a triangle. Kant argued that if countries are democratic, trade a lot with each other, and belong to shared organizations, they will be less likely to go to war. The idea is that democracy makes leaders listen to citizens who hate war; trade makes war expensive; and organizations help solve problems peacefully. Scholars have found strong evidence that the combination of all three reduces conflict.
10. Give an example of how trade liberalization could hurt the abundant factor according to Stolper-Samuelson.
Consider a country that has many low-skilled workers but very few highly skilled workers. Suppose this country opens trade and starts exporting low-skill goods like clothing. The price of clothing rises, increasing demand for low-skilled workers, so their wages go up. The scarce factor is high-skilled labor, which is used in the import-competing sector. As imports of high-skill goods come in, the price of those goods falls, reducing demand for high-skilled workers and lowering their wages. Thus, the abundant factor (low-skilled workers) gains, and the scarce factor (high-skilled workers) loses. In reality, trade patterns are more complex, but this shows how relative abundance matters. The theorem predicts that trade reduces income inequality in a developing country.
11. In the Specific Factors model, why does opening to trade create winners and losers?
Opening to trade raises the price of the exported good and lowers the price of the imported good. Owners of factors specific to the export industry gain because their product sells for more. For example, landowners in a wheat-exporting country earn higher rent. Owners of factors specific to the import-competing industry lose because their product's price falls. Factory owners in the textile sector, if textiles are imported, see lower profits. Workers (mobile labor) may gain or lose depending on what they consume and which industry they work in. Since factors cannot move immediately, the losses are concentrated, creating political pressure for tariffs. Over time, as factors move, the losses may disappear, but the model captures the short-run distributional effects.
12. How do democracy, trade, and international organizations reinforce each other for peace?
Think of each factor making the others stronger. Democracy makes leaders accountable, so they prefer peaceful trade to war. Trade creates wealthy groups that push for peace and want organizations to protect trade. International organizations set rules that make trade easier and monitor elections to ensure democracy. Also, democratic countries trust each other more, so they are willing to join organizations and trade freely. Organizations can also help new democracies stay stable, which then promotes more trade. In short, the three are like a tripod: if one leg is weak, peace is less likely. Studies show that countries with all three have almost no wars between them. For example, Canada and the US are both democracies, trade heavily, and share many organizations.