Jason,

What do you believe is the most direct cause(s) of the weakening of the dollar? Is it the trade deficit and/or spending deficits along with increased borrowing overseas? Is it offshoring? Tax cuts? And how direct is the causality of this to oil and commodity prices?

Of course I’ll give you full credit in the post for educating me more on this subject. Thanks in advance !

Sean

Below is my reply. I am posting it here for posterity, and because I think it may include one possible explanation of the weak dollar within the grasp of IB and AP Econ students:

Hi Sean,

Keep in mind, I’m no expert here, only a high school economics teacher… but let me just share a few thoughts about one cause of the weak dollar.

I think something you’ve forgotten to mention in your email is the role that the mortgage crisis has had on the dollar. Much of the debt from the sub-prime mortgage market was held by overseas investors. As home foreclosures picked up late last year, confidence in these mortgage-backed securities plummeted and demand for these American assets fell, thus demand for dollars among foreign investors has fallen with it, depreciating the dollar.

I think the housing market is at the core of a lot of our woes right now. In my econ class we talk about the “wealth effect” of falling home prices on consumer spending. Besides disposable income, the main determinant of overall consumption in the economy is the level of “wealth” among households. Of course, Americans’ greatest source of wealth is their homes… and the reason home prices have fallen is a simple supply and demand story, which is within the grasps of anyone who knows how supply and demand interact to determine price in a marketplace.

Low interest rates during the late Greenspan era spurred a period of new home sales, which drove prices up, spurring a building frenzy which shifted supply out. As long as demand increased more rapidly than supply, the illusion that house prices would continually rise was believable, thus buyers could be convinced that an adjustable rate mortgage (ARM) was the perfect type of loan for them. But the rising prices were unsustainable, and when the Fed began increasing interest rates a few years ago, demand for new homes declined, right as inventory was at an all time high. Naturally, home prices began to stabilize then fall, and as the “adjustable” part of all those “sub-prime” ARMs kicked in, monthly payments became too much for some Americans to bear. In an attempt to liquidate their now unaffordable houses, millions of Americans put their homes for sale, while thousands began to default on their loans, both which combined to shift supply ever further outward, putting even more downward pressure on home prices.

The story continues from here: falling home prices mean less “wealth” which means less consumer spending which means less total output in the economy which means less demand for workers which means rising unemployment… aka, RECESSION! And that’s where we are today.

So, as you can see I think the housing market is at the core of our problems. The weak dollar too, as demand for American homeowners’ debt has declined among foreign investors. Now, in the face of a recession, the Fed has lowered interest rates once again to try and stimulate new spending and investment, further exacerbating the dollar’s decline, as lower returns in the US bond market divert investors out of dollars and into more secure investments, such as… you guessed it, OIL.

The falling dollar had encouraged investors to look for stable investments, such as commodities like oil, copper, coal, etc, driving demand and prices for these commodities up, contributing to the cost-push inflation that has accompanied America’s economics slowdown.

So yes, it’s all connected… rising unemployment, sluggish growth, rising price levels and falling real wages. At the core, however, is the housing market and the “irrational exuberance” that led to a speculative building and buying spree over the last six years: a bubble which began bursting late last year and continues to have a ripple effect across the economy.

Bush’s tax cuts and deficit spending just made this whole mess even worse. I did a blog post a while back about the trade deficit with China, budget deficits and the value of the dollar, you can read that here: “Excuse me China, could you lend us another billion?”

Okay, that’s all I’ve got for you today… I hope some of these observations are useful!

Best, Jason

I had an email from a good friend of mine who teaches at Shrewsbury International School in Bangkok in my inbox this morning. He had seen the “SAS Responds” fund-raiding website, which I emailed to my friends last week, and wanted to let me know what his own school was doing to bring relief to the cyclone victims in Burma.

Shrewsbury has teamed up with a travel agency in Yangon that has been sending envoys of relief workers south into the delta to deliver supplies. The letter below is from an agency employee who recently returned from the delta:

People living in Town:
I talked to the local people in town and asked them why they could not help the victims. It seems they have lost all heart. The whole town was damage. In down town, beautiful old houses collapsed into pieces. I really don’t know how they are going to built it all up again. Everybody seems very poor even before the cyclone they had to try hard even for daily meals. I really have no idea how they are going to make new houses on top of nothing left. I saw people sitting in the half collapsed houses under the heavy rain. Some people’s houses are in good condition and seem good business but it seems they could not give much help to thousands of people. If they give to some the rest of the people will come and they just can’t handle this. So they close the doors.

People living in the villages and rice field.
I saw ruins of thatches and old bamboo in the rice fields. No men there as no land left. All was covered by water. Poor villagers were running after our trucks in desperate need of everything. Men, women, children are sitting each side of the road waiting for the donations. When they saw cars coming they just ran to us. Our truck driver had a hard time not to hit them. We had to advise them to line up to receive donations.

I saw sub-human levels of living. If it rains they get wet then when it is sunny again their clothes are dry again. They only have the clothes that they are wearing. We don’t have enough clothes to provide for all of them so they have to fight to get one old second hand T shirt. Dogs seem to know what was going on. They were also exciting to accompany their masters when receiving donation. Kids are just kids. They are amazing that they could still laugh. They waved to us, they smiled at us and ran after us with curiosity. When they received something they ran back to their parents full of joy!

We could not hold tears back when victims are praying and wishing best of luck to all the donors. We had to leave them behind with a heavy heart. This is about villagers we saw on our way.

People living in the refugee camp (monasteries, Pagoda, church, school compound):
We saw people living in monasteries, church, pagoda and schools. These people are homeless. Their properties are totally destroyed. Monks and churches provide them with food and shelter for a while. They don’t know how to start their life. We neither. The night we went there it was raining. When we met them in the morning we learnt that last night over 3000 people including monks had to stand all night long due heavy rain. If there is no rain they can sleep on the pagoda platform.
We donated rice bags, potatoe bags, bean bags to give them food. We asked all victims to come and sit to get small bags of rice, soap, instant noodles and potatoes to hold on to the situation till international aid comes (hopefully). We donated to more than 5000 people in the refugee camp and 2000 people on the way by hand to hand delivery. So that we make sure that they got it.

We were so glad that we could make it. It was very tiring and a risky trip but we leart more about life and to know how to value our own lives.

Thank you very much for your kindness and help

Kay Zin Tar (Ms.)

Clearly much relief is still needed for the helpless victims of the Burma cyclone. Please visit the SAS Myanmar Relief page to contribute to Shanghai American School’s efforts to help International Development Enterprises bring relief to the Irrawaddy Delta cyclone victims!

The cute little green alien-looking computer that is the XO PC (aka the “$100 computer” that costs $200) is now available with Windows XP. For anyone who’s had a chance to play with one of these machines, the Linux based operating system takes some getting used to for those of us used to the familiarity of Windows.

As it would turn out, education ministries in the developing world, the market the “one laptop per child” program targets for its cheap, durable PC, prefer machines with Windows on them over the unfamiliar Linux system as well:

…some countries, such as Egypt, want machines that run Windows, the most common personal computer operating system in the developed world.

“They said we would be in a much better position with a Windows-capable machine,” he said.

Meanwhile, Microsoft was working on a version of its Windows XP operating system that would work on the relatively low-powered XO computer.

“Lo and behold, they finalized [it] and have a very crisp-running machine with XP on it,” Kane said.

A statement from Microsoft said the Windows XP version of the XO will be capable of using hundreds of thousands of Windows-compatible programs and hardware accessories.

My first thought at this news was, “well, there goes any chance at achieving a $100 laptop for poor children in the developing world…” Windows XP, which retails for aroudn $250 in the rich world, would push the price of an XO from $200 to $450, if Microsoft were to charge the retail price for its operating system, that is.

In fact, Microsoft is making its popular operating system available for $3 per XO, which is probably close to the actual marginal cost to Microsoft of producing additional copies of XP. What’s the incentive for Microsoft to make this apparently charitable gesture to the OLPC program?

Mike Cherry, lead analyst for Windows at Directions on Microsoft, an independent software-research firm in Kirkland, Wash., said Microsoft doesn’t want cheap Linux-based computers to threaten the dominance of Windows.

“Let’s say they put Linux on there, and people say, ‘Hey this works pretty good,’ and they start looking at it for other applications as well,” he said. Getting Windows onto the XO laptop is one way to prevent this.

“I think it’s along the lines of not allowing anybody else to get a toehold,” Cherry said.

Sometimes when companies like Microsoft act in the pursuit of their own self-interest, society as a whole benefits. In economics we call this predatory pricing. Two firms, Microsoft and Linux, are competing for a larger foothold in developing countries where more new PC users are expected to emerge in the coming decades than anywhere else.

In the name of competition and its desire to maintain market share, Microsoft has taken a product that it usually charges the full monopolist price of $250 for and reduced its price to the marginal cost of $3. To prevent all PC users from taking advantage of this massive price reduction, however, the company will only make the $3 version of XP available on the XO, assuring that only the poorest, most technologically deprived consumers benefit from the company’s price discrimination.

While the price of the XP ready XOs will be about $10 higher, the ability to run thousands of Windows programs will surely give the OLPC program a greater appeal to education ministers and government officials in the developing world. Don’t be surprised if in the near future we begin to see more and more of the little green alien machines in the hands of the developing world’s school children.

The problem is, increased consumption usually means rising prices, as can be clearly illustrated in an aggregate demand / aggregate supply diagram. Household spending makes up somewhere around 40% of China’s GDP, exports, government spending and investment account for the rest. Whenever one component of total expenditures increase in the economy, all other things equal, the price level will rise.

Only two things could happen to make the Chinese leadership’s goal of increased consumer spending and stable prices a reality: either productivity in the economy must increase more rapidly than consumer spending, shifting aggregate supply outward, or another component of aggregate demand must be reduced more rapidly than consumption increases, offsetting the increase in overall expenditures cause by rising consumption.

So what magical combination of fiscal and monetary policy can be employed to both increase consumption and stabilize the price level? The answer may not rest purely in the realm of domestic macroeconomic policy-making, but rather in the foreign exchange markets, where a weak RMB has kept domestic consumption low and net exports (thus the price level) high. Allowing the RMB to appreciate should make “magic” happen and lead to rising domestic consumption and disinflation simultaneously:

A stronger currency, commensurate with China’s increased economic strength, would both tamp down inflation and allow Chinese consumers to buy more goods and services. However, for reasons not entirely clear to me, or few others for that matter, China’s leaders are resisting this simple and beneficial solution.

The Chinese leadership’s stated goal in prodding their citizens to spend more is to decrease their economy’s dependence on exports. If the Chinese, who currently save 50 percent of their incomes, saved less, more of their production would be consumed locally. As a result, China would be less vulnerable to economic downturns abroad. Without a vibrant domestic market, over-leveraged Americans will apparently remain China’s most important customers.

A strengthened yuan would lower the real costs of goods for domestic consumers and allow the Chinese themselves to compete more evenly with consumers in other nations to whom they currently send the fruits of their labor. As goods become more affordable in China, the Chinese would naturally consume more. A rising yuan would therefore kill two birds with one stone: it would reverse recent consumer price increases and it would induce Chinese consumers to buy their own products.

Some members of the US Congress estimated sometime last year that the Chinese currency was undervalued by 27%, leading certain politicians to call for an across the board tariff on all Chinese imports to the United States. Such protectionist sentiment was not uncommon 12 months ago, but as America faces its own economic slowdown, compounded by rising inflation and the falling value of the dollar, such calls for more taxes on imports have disappeared from Washington.

The sensible action for the Chinese to take in response to its own overheating economy (letting the RMB appreciate in order to relieve inflation and encourage domestic consumption) could spell economic doom for the US. As China adopts a “strong yuan” policy, its demand for US dollar-denominated financial assets, including government debt, will decline, reducing demand in the US bond market, lowering bond prices and driving up interest rates in the US. Higher US rates will discourage investment and consumption, exacerbating the slowdown already underway in America. Furthermore, reduced demand for US assets by China will cause demand for the dollar to slide in foreign exchange markets. Since much of American’s household spending is on imports, inflation will rise in America as not only Chinese goods, but all imports, are now more expensive to Americans.

Usually in economics class, we adopt the frame of mind that economics is not a zero-sum game. In other words, through free trade based on comparative advantage and specialization, individuals and nations will benefit due to increased total output, increased productivity, higher incomes, and greater variety of goods and services produced within and among communities and nations. In the case of China and the US today, on the other hand, we appear to be in a situation where increased consumption by Chinese may be achievable only at the expense of American consumers, who because of rising interest rates and a falling dollar, may be forced to live “within their means” for the first time in decades.

Discussion questions:

1. Why is a strong RMB necessary to simultaneously increase consumption and reduce inflation in China?
2. Why would interest rates in the US rise if China adopted a “strong RMB” policy?
3. Would Americans be better off without trade with China? What about the statement that Americans will be worse off if China is to achieve greater levels of domestic consumption?

With the official death count at 130,000 and rising, millions more still need help in the Irrawaddy Delta of Myanmar, where Cyclone Nargis swept through on May 2 destroying homes and lives in thousands of villages.

Shanghai American School is responding to the disaster by sponsoring International Development Enterprises, one of the only international NGOs with people on the ground in Burma. 125 of their staff are already in villages, constructing temporary shelters and providing 200 gallon water tanks to provide fresh water. Their resources are running thin, however, and they need our help.

Follow the link to our fundraising page above, or follow our progress towards our goal of 5,000 GBP in the widget to the right. When you’re ready to help out, click on the link and make your donation! Every little bit helps!

With thanks, Jason

In this post I will reflect on the FRQs from the macroeconomics exam.

First, question 1: An imaginary country operating at full employment experiences a deficit financed increase in government spending.

Part (a) asks students what the impact of the new government spending will be on aggregate demand and aggregate supply. Easy enough! Since “G” is a component of AD, an increase in government spending will shift AD out while short-run aggregate supply remains the same.

Part (b) is simply a graphical representation of the answer to part (a), asking students to show the effect on output and price level. The new government spending will increase output and the price level.

So far, the question has been very straightforward and what I’d consider easy for even weaker students. In part (c), the question asks students to show the impact that the government’s borrowing from the public has on the real interest rate and the market for loanable funds. Here I am guessing the AP readers will accept either a leftward shift of supply or a rightward shift of demand. The question does not ask students to explain the shift, only “show”. Either demand or supply can shift when the government increases its deficit through issuing new bonds, as I explained HERE.

Finally, parts (d) and (e) broaden the scope of this question to international economics, a section of the syllabus that was not traditionally included in the long free response questions, but has been for two years now, and I expect it will continue to be a theme of the FRQs in the future.

Part (d) asks what effect higher real interest rates will have on supply of the country’s currency on foreign exchange markets and the value of the currency. My answer would be that as real interest rates rise households will save more, spend less on imports, thus supply less of their currency, causing it to appreciate on foreign exchange markets. This question may have stumped some kids. I typically teach that higher real interest rates will increase demand for a country’s currency, as foreigners direct their financial capital into the country’s financial markets in pursuit of higher real returns on their investments.

Finally, part (e) is simple enough, asking the impact of the now appreciated currency on net exports. As the country’s goods become more expensive to foreigners, net exports will decline, possibly offsetting the initial increase in government spending.

Overall I’d say that FRQ number 1 was FAR easier than last year’s FRQ on which students had to illustrate the impact of rising exports from New Zealand on the country’s money market and its real interest rates, also involving an explanation of how Australia’s economy might recover from a recession without any government action, requiring an understanding of the neo-classical theory of flexible wages, vertical aggregate supply, and self-correction… overall a MUCH tougher question than this year’s!

Stay tuned for my impression of numbers 2 and 3 of the 2008 form B FRQs!

Smith’s observations of man’s moral sentiments form a sharp critique of our so-called humanity. Smith asks whether a man would willingly accept the deaths of millions in a far off land in order to prevent the slightest injury upon himself. If so, then what is it that motivates man to strive to relieve the suffering of the victims of disasters in far off places such as Sichuan Province in China and the Irrawaddy Delta in Mayanmar.

“Let us suppose that the great empire of China, with all its myriads of inhabitants, was suddenly swallowed up by an earthquake, and let us consider how a man of humanity in Europe, who had no sort of connection with that part of the world, would be affected upon receiving intelligence of this dreadful calamity.

He would, I imagine, first of all, express very strongly his sorrow for the misfortune of that unhappy people, he would make many melancholy reflections upon the precariousness of human life, and the vanity of all the labours of man, which could thus be annihilated in a moment. He would too, perhaps, if he was a man of speculation, enter into many reasonings concerning the effects which this disaster might produce upon the commerce of Europe, and the trade and business of the world in general. And when all this fine philosophy was over, when all these humane sentiments had been once fairly expressed, he would pursue his business or his pleasure, take his repose or his diversion, with the same ease and tranquility, as if no such accident had happened.

The most frivolous disaster which could befall him would occasion a more real disturbance. If he was to lose his little finger to-morrow, he would not sleep to-night; but, provided he never saw them, he will snore with the most profound security over the ruin of a hundred millions of his brethren, and the destruction of that immense multitude seems plainly an object less interesting to him, than this paltry misfortune of his own.

To prevent, therefore, this paltry misfortune to himself, would a man of humanity be willing to sacrifice the lives of a hundred millions of his brethren, provided he had never seen them? Human nature startles with horror at the thought, and the world, in its greatest depravity and corruption, never produced such a villain as could be capable of entertaining it. But what makes this difference? When our passive feelings are almost always so sordid and so selfish, how comes it that our active principles should often be so generous and so noble? When we are always so much more deeply affected by whatever concerns ourselves, than by whatever concerns other men; what is it which prompts the generous, upon all occasions, and the mean upon many, to sacrifice their own interests to the greater interests of others?

It is not the soft power of humanity; it is not that feeble spark of benevolence which Nature has lighted up in the human heart that is thus capable of counteracting the strongest impulses of self-love. It is a stronger power, a more forcible motive, which exerts itself upon such occasions. It is reason, principle, conscience, the inhabitant of the breast, the man within, the great judge and arbiter of our conduct. It is he who, whenever we are about to act so as to affect the happiness of others, calls to us, with a voice capable of astonishing the most presumptuous of our passions, that we are but one of the multitude, in no respect better than any other in it; and that when we prefer ourselves so shamefully and so blindly to others, we become the proper objects of resentment, abhorrence, and execration.

It is from him only that we learn the real littleness of ourselves, and of whatever relates to ourselves, and the natural misrepresentations of self-love can be corrected only by the eye of this impartial spectator. It is he who shows us the propriety of generosity and the deformity of injustice; the propriety of resigning the greatest interests of our own, for the yet greater interests of others, and the deformity of doing the smallest injury to another, in order to obtain the greatest benefit to ourselves.

It is not the love of our neighbour; it is not the love of mankind, which upon many occasions prompts us to the practice of those divine virtues. It is a stronger love, a more powerful affection, which generally takes place upon such occasions; the love of what is honourable and noble, of the grandeur, and dignity, and superiority of our own
characters.”

Any thoughts?

Candidates running for President in the United States often campaign to potential voters that “the United States has 7.5 million Americans out of work”, which is very true. But I say, “Wow, where does the U.S. pick up its’ first-place trophy for being so excellent at employment.” To me, having only 7.5 million out of work is like getting a 5 on yesterday’s AP Macro test! Of course, 7.5 million unemployed in the United States is only 5.0% of our 150 million labor force, and the unemployed workers consist almost entirely of “frictionally” and “structurally” unemployed workers. Frictionally unemployed workers are those workers who are transitioning between jobs or entering the job market. This transitional unemployment is a normal and desirable occurrence in any market-based economy as it evidences free choice. Structurally unemployed workers are also a by-product of a successful, market-based economy as workers are only temporarily unemployed, for the long-run benefit of the economy, as new automated technologies are replacing manual labor, and/or trade agreements are implemented allowing a country’s citizens to purchase less expensive, but still high-quality imported products. Let me be sarcastic for a moment: maybe we can get the U.S. Government to pass two new laws to lower their unemployment rate; one law to outlaw new technology so they can reduce their structural unemployment, and a second law to prevent their citizens from quitting their current jobs so the country can reduce the frictional portion of the unemployment rate as well. Maybe after that (I’m still being sarcastic if you hadn’t noticed!) the U.S. Government will then establish a new goal of 0% unemployment, which is what I hear the unemployment rate is in the US prison work camps!

Another specific example of this “180 degree moment” relating to unemployment is that manufacturing in the U.S. is somehow declining. This misperception has been created primarily on the large loss in U.S. manufacturing jobs and the declining share of manufacturing jobs as a percentage of total U.S. jobs over the last 20 years. It is widely believed that the U.S. global share of manufactured products has decreased which is an incorrect belief. Basically, the misperception has been created because: 1) employment in manufacturing is at an all time low, and 2) the U.S. has increased their share of imports from countries like Japan and China.

The reality, however, is that U.S. Manufactured real product has more than doubled over the last 20 years and they have accomplished this feat with an amazing increase in worker productivity via technology. U.S. manufacturing output per employee has increased markedly due to technology and the effective use of capital.

Yes, I believe “down often really is up”, and “black often really is white”!