Market failures exist all around us. Until you have studied the concept, however, you would probably never know it! Not all market failures are in the form of pollution, however, and in fact many of the goods that are beneficial to society can be pointed to as examples of market failure.
If a good creates external benefits for society beyond those enjoyed by the consumer of the good itself, it is said to create positive externalities of consumption. Condoms are an example of such a good; when an individual uses a condom when having sex, he enjoys several private benefits, such as reducing the chance of becoming infected with a sexually transmitted disease and reducing the likelihood of an unwanted pregnancy. However, the benefits for society of condom use are much greater, and include lower HIV and other STD infection rates, thus a healthier, more productive population, lower birth rates thus less pressure on resources from excessive population growth. These are external benefits of condom use, which means they will not be considered when an individual decides whether or not he will use a condom when engaging in sex.
Using the terminology of market failure, the marginal social benefits of condom use exceed the marginal private benefits. Thus, when left to the free market, the quantity of condoms consumed will be less than the socially optimal quantity. Not enough people will use protection when having sex: birth rates will be higher than desired, HIV infection rates will be higher and society as a whole will bear the costs of unsafe sexual activity.
In India, a developing country where the average woman still has nearly three children in her life, population growth threatens to put increasing pressure on the nation’s resources. Therefore, the country could benefit greatly from increased use of condoms. The video below demonstrates an attempt by non-governmental organizations to increase awareness among Indian males about the purpose and appropriate use of condoms.
Watch the video and respond to the questions that follow:
Discussion Questions:
What approach does the video take to correcting the market failure in the use of condoms?
Why is condom use lower than what is socially optimal in India?
Is this video an example of a commercial, or is it a public service announcement? What’s the difference?
Do you think it will work? How would we know if the video succeeded or failed?
One of the most prominent economists of the 20th century was the late Milton Friedman, an ardent free market supporter who remained skeptical of government’s ability to correct market failures through interventionist policies.
I found the talk below interesting. Friedman offers several examples of market failures that have been pointed to as a justification for government intervention, and argues that in fact, government often does not truly know what the right outcome is in most cases. He believes that government failure should be just as much a concern as market failure; and that therefore societal welfare would be best met by finding market-based solutions to the misallocation of resources that sometimes arises under conditions in which externalities exist.
As you watch the video, consider Friedman’s claims regarding the role of government, then post your response to one of the discussion questions below.
Discussion Questions:
Is government better able to know the “optimal” quantity of output of different goods and services than private individuals are?
Under what conditions would the free market be best able to achieve solutions to market failures such as those described by Friedman?
What do you think should be of greater to concern to society, market failure or government failure?
Story #6: Sweatshops and Story #7: Toxic chemicals (watch up to 11 minutes)
Discussion Questions:
Which of the stories above is about public goods, or goods which would not be provided at all if left entirely to the free market? Explain.
Which of the stories above is about demerit goods, or ones which would be over-provided by the free market due to their negative effects on the environment or human health? Explain.
Which of the stories above is about merit goods, or ones which are provided by the free market, but at a quantity below which is socially optimal due to the fact that they create spillover benefits for society as a whole.
Which of the stories describes a good or goods which the government currently regulates the production of? Which goods does government currently NOT regulate the production of?
What makes each of the stories above examples of market failure?
The chart below shows how the value of the Swiss franc has changed against the Indian rupee over the last year and a half.
The Value of the Swiss Franc in terms of India Rupees – last 18 months
As can be seen, the franc, which is the currency in which I get paid here in Switzerland, has risen from only 40 rupees 18 months ago to as high as 63 rupees in August this year, and is currently at 57 rupees per Swiss franc. We’ll explore the underlying causes of this appreciation of the franc in a moment, but first let’s examine its effect on my dream of skiing in the Himalayas.
So just yesterday morning I did, at last, after six years of dreaming of this adventure, book a six day guided ski trip in the Indian Kashmir town of Gulmarg, which sits at an elevation of 2800 meters and has lift-accessed skiing up to 4,000 meters, making Gulmarg the second highest ski resort in the world. Okay, enough facts. The strong franc made this trip a reality for me for the following reason:
18 months ago, the 40,000 rupee price tag of this ski trip would have meant a cost of 1,000 swiss francs.
Today, due to the strong franc, the 40,000 rupee price tag means this trip is only costing me 700 swiss francs.
Due to the strengthening of the franc, and the weakening of the rupee, my Himalayan ski odyssey is now costing me 30% less than it would have 18 months ago… so… I’m doing it! YEAH!
-
The Swiss currency has appreciated by 42.5% in the last 18 months against the India rupee. WHY?! What could be going on in the world that accounts for this massive swing in exchange rates? There are a few causes worth mentioning here, which have to do with factors within Switzerland and India, but also external factors beyond the control of either country. Here are some of the major ones:
-
In Europe:
The franc has risen against most world currencies, not just the rupee, due, ironically, to economic uncertainty in the rest of Europe. Since Switzerland has its own currency, and a strong economy, whereas all of its European neighbors have a common currency (the euro), and struggling economies, investments in Swiss assets (primarily savings accounts and government debt) have become increasingly attractive. This has caused demand for francs to rise, causing its value to increase against most currencies.
The debt crisis in the rest of Europe, most notably in Greece and Italy, reduces certainty among investors in these European governments’ ability to repay their debt, creating further demand for investment in Switzerland, causing the franc to rise.
In India:
According to the Associated Press, “Slowing growth, a swelling current account deficit and waning investor interest in India are adding to pressure on the rupee…” India runs a large trade deficit, equaling about 3% of the nation’s GDP. This means Indians are dependent on imported goods, while foreigners do not demand as many of its exports. This puts downward pressure on the exchange rate of the rupee.
In addition, the “slowing growth” rate in India sends the signal that the country’s central bank may lower interest rates to try and stimulate GDP. However, the expectations of lower interest rates in the future make international investors look elsewhere for investments with relatively higher returns.
Next, weaker growth prospects make investments in Indian assets (such as corporate stocks or bonds) less attractive to international investors, since they expect demand for Indian output to slow in the future, thus demand for rupees declines now.
Finally, the decline in the rupee’s value itself is fueling a further increase in the value of the franc. Not all currency exchanges are for the purpose of purchasing a nation’s goods or its assets. Much currency trading is among forex brokers who buy and sell currencies to hold as assets themselves. The weakening of the rupee may be fueling speculation about the future value of the rupee, which acts as a self-fulfilling prophecy, as forex investors will continue to swap rupees for other currencies, including the Swiss franc.
All this adds up to one thing for me: A 30% discount on my ski vacation to India! Of course, for the Indian economy, a weaker rupee might be just what is needed to boost future economic growth. As the rupee falls and the Swiss franc and the US dollar gain value, not only will ski vacations to India become more attractive to foreigners, but so will other exports from the South Asian nation. That 3% trade deficit that has contributed to the rupee’s decline may begin to move towards the positive if foreigners like me begin taking more trips to and buying more goods from Indian firms.
-
The weaker rupee could, in the long-run, increase total demand for India’s output, which would improve employment and growth prospects on the sub-continent. Furthermore, if India’s growth rate picks up due to increased net exports, the Indian central bank may be able to raise interest rates a bit, reducing the incentive for investors to flee the rupee and put their money in countries with higher returns.
-
Through this process of self-balancing, in time the weaker rupee will probably lead to an improvement in India’s economic situation and eventually the rupee will begin to strengthen against the currencies of India’s trading partners. But for now, I’m going to enjoy my week of guided skiing in the Himalayas, and thank the forex traders and currency speculators for allowing me to take this dream vacation for such a bargain price!
To spend or not to spend. That is the question. In order to determine whether or not a government should increase its budget deficit in order to stimulate economic activity in its economy, it is important to determine whether said deficit spending will lead to a net increase in the nation’s GDP or a net decrease in GDP. Obviously, if increasing the debt to pay for a government spending package leads to lower aggregate demand in the economy, then it should not be undertaken. However, if a deficit-financed spending package leads to an overall increase in output and national income, it may be justified.
To understand the circumstances under which a government stimulus package will increase or decrease overall output in the economy, we must compare two competing possible impacts of a government stimulus. The multiplier effect of government spending refers to a theory which says that any increase in government spending will lead to further increases in private spending, as households enjoy more income and thus consume more and firms, which earn more revenues due to the government’s increased spending, make new capital investments, contributing to the stimulus provided by government and leading to an overall increase in GDP that exceeds the increase in government spending.
The crowding-out effect, on the other hand, refers to the theory that any increase in government spending, when financed by a larger deficit, will lead to a net decrease in private expenditures, as firms and households face higher interest rates due to the governments’ intervention in private financial markets. Government spending will crowd out private spending, thus any increase in spending will be off-set by a decrease in private spending, possibly even reducing overall income in the nation.
This post will focus on the second of these effects, and attempt to explain the circumstances under which crowding-out is likely to occur, and those under which it is unlikely to occur.
Deficit-financed government spending refers to any policy that increases government expenditures without increasing taxes, or one that reduces taxes without reducing government expenditures. In either case, a government must increase the amount of borrowing it does to pay for the policy, which means governments must borrow from the private sector by issuing new debt in the form of government bonds.
When a government must borrow to spend, it has to attract lenders somehow, which may require the government to offer higher rates of return on its bonds. The impact this has on the supply of private savings, which refers to the funds available in commercial banks for lending and borrowing in the private sector, will be negative. In other words, the supply of loanable funds in the private sector will decrease.
The graph below shows the market for loanable funds in a nation. The supply curve represents all households and other savers who put their money in private banks, in which they earn a certain interest rate on their savings. The demand for loanable funds represents private borrowers in the nation, who demand funds for investments in capital and technology (firms) and durable goods and real estate investments (households). The demand for loanable funds is inversely related to the real interest rate in the economy, since higher borrowing costs mean less demand for funds to pay for investment and consumption.
When a government needs to borrow money to pay for its deficit, private savers (represented by Slf above) will find lending money to the government more attractive than saving in private banks, since the relative interest rate on government bonds is likely to rise. This should reduce the supply of loanable funds in the private sector, making them more scarce and driving up borrowing costs to households and firms. This can be seen below:
In the illustration above, a government’s deficit spending crowds-out private spending, as firms and households find higher interest rates less attractive and thus demand less funds for investment and consumption. Private expenditures fall from Qe to Q1; therefore any increase in economic output resulting from the increase in government spending may be off-set by the fall in private spending. Crowding-out has occured.
Another way to view the crowding-out effect is to think about the impact of increased government borrowing on the demand for loanable funds. Demand represents all borrowers in an economy: households, firms and the government. An increase in public debt requires the government to borrow funds from the private sector, so as the supply of loanable funds fall, the demand will also increase, although not from the private sector, rather from the government. The effect this has can be seen below:
In the graph above, both the reduced supply of loanable funds resulting from private savers lending more to the government and the increased demand for loanable funds resulting form the government’s borrowing from the private sector combine to drive the equilibrium interest rate up to IR2. The private quantity demanded now falls from Qe to Qp, while the total amount of funds demanded (from the private sector and the goverment) now is only Qp+g. This illustration thus shows how an increase in government borrowing crowds out private spending but also leads to an overall decrease in the amount of investment in the economy.
Based on the two graphs above, a deficit-financed government spending package will definitely crowd-out private spending to some extent, and in the case of the second graph will even lead to a decrease in overall expenditures in the economy. This analysis could be used to argue against government spending as a way to stimulate economic activity. But this analysis makes some assumptions that may not always be true about a nation’s economy, namely that the equilibrium level of private investment demand and the supply of loanable funds occurs at a positive real interest rate. There are two possibilities that may mean the crowding-out effect does not occur. They are:
If the private demand for loanable funds is extraordinarily low, or
If the private supply of loanable funds is extraordinarily high.
When might these conditions be met? The answer is, during a deep recession. In a recession, household confidence is low, therefore private consumption is low and savings rates tend to rise, increasing the supply of funds in private banks. Also, firms’ expectations about the future tend to be weak, as low inflation or deflation make it unlikely that investments in new capital will provide high rates of return. Home sales are down and consumption of durable goods (which households often finance with borrowing) is depressed. Essentially, during a recession, private demand from borrowers is low and private supply from households is high. If the economy is weak enough, the loanable funds market may even exhibit an equilibrium interest rate that is negative. This could be shown as follows:
Notice that due to the exceedingly low demand and high supply of loanable funds, 0% acts as a price floor in the market. In other words, since interest rates cannot fall below 0%, there will be an excess supply of funds available to the private sector. Such a scenario is known as a liquidity trap. The level of private investment will be very low at only Qd. Banks cannot loan out all their excess reserves, and even though borrowing money is practically free, borrowers aren’t willing to take the risk to invest in capital or assets that may have negative rates of return, a prospect that is not unlikely during a recession.
So what happens when government deficit spends during a “liquidity trap”, as seen above? First of all, the government need not offer a very high rate to borrow in such an economy. Private interest rates will be close to zero, so even a 0.1% return on government bonds will attract lenders. So the supply of loanable funds may decrease, and demand may increase, but crowding-out will not occur because there is almost no private investment spending to crowd out! Here’s what happens:
Here we see the same shifts in demand and supply for loanable funds as we saw in our first graph, except now there is no increase in the interest rate resulting from the government’s entrance into the market. Since private interest rates stay at 0%, the private quantity of funds demanded for investment remains the same (Qp), while the increased government borrowing leads to an increase in overall spending in the economy from Qp to Qp+g. Rather than crowding-out private spending, the increase in government spending has no impact on households and firms, and leads to a net increase in overall spending in the economy.
If the government spends its borrowed funds wisely, it is possible that private spending could be crowded-in, which means that the boost to total output resulting from the fiscal stimulus may increase firm and household confidence and shift the private demand for loanable funds outwards, increasing the level of private investment and consumption, further stimulating economic activity.
So what have we shown? We have seen that in a healthy economy, in which households and firms are eager to borrow money to finance their spending, and in which savings rates are not exceedingly high, government borrowing may drive up private interest rates and crowd-out private spending. But during a deep recession, in which consumer spending is depressed and firms are not investing due to uncertainty and savings rates are higher than what is historically normal, an increase in government spending financed by a deficit will have little or no impact on the level of private investment and consumption. In such a case, governments can borrow cheaply (at just above 0%), and increase the overall level of demand in the economy without harming the private sector.
Crowding-out is a valid economic theory, but its likelihood of occurring must be evaluated by considering the actual level of output and employment in the economy. In a deflationary setting, in which savings is high and private spending is low, government may have the opportunity to boost demand and stimulate growth without driving up borrowing costs in the private sector and decreasing the level of household and firm expenditures.
Related Unit: IB Economics Unit 4.7 – Balance of Payments (Unit 3.3 in the new IB Economics syllabus)
Topic: The Marshall Lerner Condition and the J-Curve
Learning Goals/Objectives:
For students to understand that the levels of price elasticity of demand for a country’s imports and exports determines whether a depreciation or devaluation of the country’s currency will move the nation’s balance of payments towards a surplus or a deficit.
For students to understand the impact of time on the effect of a depreciation or devaluation of a nation’s currency on its balance of payments in the current account.
For students to evaluate the argument that a country will always benefit from a weaker currency.
Test of prior knowledge:
Define ‘price elasticity of demand’ and explain how it is measured.
With the use of examples, explain why some products have low price elasticity while others have a high elasticity. With the use of examples, explain why the price elasticity of demand for some goods changes over time
Explain how the depreciation of a country’s exchange rate might affect its current account balance. IS THIS ALWAYS THE CASE?
How might the PED for exports and imports influence the balance on the current account following a change in the value of a nation’s currency?
Process:
Each student should research the forex market for his or her home country in the United States. If you are American, research the forex market for the dollar in Europe.
Using Yahoo Finance, research exchange rate data from the two countries two years ago up to today.
Use Yahoo’s software to create two a line graph plotting the value of your currency in terms of dollars. For your initial graph, show the exchange rates over a two year period. For example:
The exchange rate of Japanese Yen in the United States over the last two years:
Next create a Google Doc (shared with your teacher) of your answers to the following questions. Include in the presentation the graph of the exchange rates created in the step above.
Questions to answer in your Google Doc:
Create a graph of your currency’s exchange rate in the US over the last two years. Take a screen shot and save it to your computer as an image. Insert the chart into your Google Doc. Write a one paragraph description of the changes in your country’s exchange rate over the last two years. (2 marks)
Focus on two specific time periods from during the last two years: One in which your currency appreciated noticeably and one in which it depreciated noticeably. These could be periods of just a couple of days or longer periods of weeks or more. (4 marks)
In Yahoo Finance, narrow the range of dates shown on your chart to the distinct period in which your currency strengthened and another period during which it weakened. Take a screen shot of the new graphs you’ve created, save them to your computer and upload them into the Google Doc.
Under each new chart, describe what is happening to the value of your currency in the two periods identified.
Beneath your two new graphs, explain TWO factors that may have caused the currency to change in value. (2 marks)
Given the changes to the exchange rate you identified above, what would you predict would happen to your country’s current account balance over the two periods identified? Explain. (4 marks)
Following appreciation (2 marks)
In the short-run
In the long-run
Following depreciation (2 marks)
In the short-run
In the long-run:
For both the period of appreciation and the period of depreciation you identified above, explain the impact of the change in exchange rates on the following (4 marks)
a firm that imports its raw materials from the other country
a firm that exports its finished products to the other country
consumers who buy imports from the other country
a firm that produces good for the domestic market and competes with firms from the other country
Why does the price elasticity of demand for imports and exports increase over time following a change in a country’s exchange rate? (2 marks)
Why will a depreciating currency worsen a country’s current account balance in the short-run? Assuming the currency remains weak, how would the current account balance change over time. (2 marks)
Draw a J-Curve showing the likely change in your nation’s current account balance following the period of depreciation of its currency shown in your chart above and explain its shape, referring to your country’s currency. (2 marks)
Some applaud the dollar’s fall because they believe it makes U.S. exports less expensive and that higher demand will cut the trade deficit. The downside of a low-value dollar is that it makes all the imports we consume more expensive, including raw material and parts used by U.S. businesses, and makes it costlier for U.S. dollar holders to travel or invest outside the U.S. A continued drop in the dollar’s value could destabilize the international economy, leading to a worldwide recession.
Why might the weaker dollar worsen the US trade deficit? Under what conditions would the weaker dollar improve America’s trade deficit? (2 marks)
Some argue our large trade deficit (or current account deficit) is responsible for the fall in the dollar’s value. They have it backward. It is the flow of foreign investment dollars (the capital account) into the U.S. economy that drives the trade deficit.
How does a large financial (capital) account surplus allow the United States to maintain a large current account deficit? (2 marks)
The world now is actually on a two-currency standard — the dollar and the euro. China in effect has fixed its currency to the dollar for the last two decades, and the Japanese central bank only allows the yen to fluctuate within a limited range against the dollar.
How do exchange rate controls by China and Japan reduce the likelihood that a weaker dollar will improve the United States’ current account balance? (2 marks)
So long as the U.S. continues to offer a higher return on capital than its foreign competitors, both foreign banks’ and private investors’ demand for dollars grow, and the current account deficit can be sustained.
If investments in the United States began earning lower returns relative to investments in other countries’ financial and capital markets, what would ultimately happen to the US balance of payments in its current and financial accounts? Explain (2 marks)
Total 30 marks – You have two class periods to work on this assignment. It will be graded as a “coursework” grade and counted towards your semester 1 report. To earn full marks, it must be completed by the end of the second class period.
The tools of economics can be applied to almost any social institution, even the decision of individuals in society whether or not to have children. All over the rich world today, potential parents have decided against having babies, the result being lower fertility rates across much of Europe and the richer countries in Asia, including Japan, South Korea and Singapore. Lower fertility rates have some advantages, such as less pressure on the country’s natural resources, but the disadvantages generally outweigh the benefits.
The story below, from NPR, explains in detail some of the consequences of declining fertility rates in the rich world, and identifies some of the ways governments have begun to try to increase the fertility rates.
The problem of declining fertility rates can be analyzed using simple supply and demand analysis. In the graph below, we see that the marginal private cost of having children in rich countries is very high. The costs of having children include not only the monetary costs of raising the child, but the opportunity costs of forgone income of the parent who has to quit his or her job to raise the child or the explicit costs of child care, which in some countries can cost thousands of dollars per month. Marginal private cost corresponds with the supply of babies, since private individuals will only choose to have children if the perceived benefit of having a baby exceeds the explicit and implicit costs of child-rearing.
The marginal private benefit of having babies is downward sloping. This reflects the fact that if parents have just one or two children, the benefit of these children is relatively high, due to the emotional and economic contributions a first and second child will bring to parents’ lives. But the more babies a couple has, the less additional benefit each successive child provides the parents. This helps explain why in an era of increased gender equality, families with three or more children are incredibly rare. The diminishing marginal benefit experienced by individual couples applies to society as a whole as well, therefore the market above could represent either the costs and benefits of individual parents or of society at large.
Notice, however, that that the marginal social benefit of having babies is greater than the marginal private benefit. In economics terminology, there are positive externalities of having babies; in other words, additional children provide benefits to society beyond those emotional and economic benefits enjoyed by the parents. The podcast explained some of these external, social benefits of having children: a larger workforce for firms to employ in the future, more people paying taxes, allowing the government to provide more public goods, more workers supporting the non-working retirees of a nation, and more competitive wages in the global market for goods and services. Higher fertility rates, in short, result in more economic growth and higher incomes for a nation.
When individuals decide how many children to have, they make this decision based solely on their private costs and benefits, since the external benefits of having more babies are enjoyed by society, but not necessarily by the parents themselves. Therefore, left entirely alone, the “free market” will produce fewer babies (Qe) than is socially optimal (Qso).
So what are Western governments doing about low fertility rates? The podcast identifies several strategies being employed to narrow the gap between Qe and Qso. In Australia households receive a $1000 subsidy for each baby born. In Germany mothers receive a year of paid leave from work. Here in Switzerland mothers get three months of government paid leave and $200 a month subsidy to help pay for child care after that. Each of these government policies represents a “baby subsidy”. In the graph above, we can see the intended effect of these policies. By making it more affordable to have children, governments are hoping to reduce the marginal private cost to parents, encouraging them to have more children, which on a societal level should increase the number of babies born so that it is closer to the socially optimal level (Qso).
Unfortunately, as the podcast explains, it appears that parents are relatively unresponsive to the monetary incentives governments are providing. This can be explained by the fact that the private demand (MPB) for babies is highly inelastic. Even if the “cost” of having a baby falls due to government subsidies, parents across the Western world are reluctant to increase the number of babies they have.
As we can see in the graph above, a subsidy for babies reduces the marginal private cost of child-rearing to parents. But the MPB curve, representing the private demand for babies, is highly inelastic, meaning the large subsidy has minimal effect on the quantity of babies produced. Without the subsidy, Qe babies would be born, while with the subsidy only Qs are born, which is closer to the socially optimal number of births at Qso, but still short of the number of births society truly needs.
The “market for babies” in rich countries is failing. Because of the positive externalities of having children, parents are currently under-producing this “merit good”. One of two things must happen to resolve this market failure. Either the marginal private costs of having babies must fall by much more than the government subsidies for babies have allowed, or the marginal private benefit must increase. Either larger subsidies are needed, or some moral revival aimed at encouraging potential parents to consider both the private and social benefits of having children when making their decisions.
Don’t you love economics? We make everything seem so logical! And like they say, it all comes down to supply and demand!
Discussion Questions:
What makes low fertility rates among parents in the rich world an example of a “market failure”?
What are the primary reasons fertility rates are lower in the rich world than they are in the developing world?
What are the economic consequences of lower birth rates? What are the environmental consequences of lower birth rates? Should government be trying to increase the number of babies born?
Why have government incentives for parents to have more babies failed to achieve the fertility rates that government wish they would achieve?
Do you believe that government can create strong enough incentives for parents to have more babies? If not, what will become of the populations of Western Europe and the rich countries of Asia given today’s low fertility rates? Should we be worried?
American consumers are a curious bunch. Up until 2007, the average savings rate in the United States fell as low as 1%, and during brief period was actually negative. What does negative savings actually mean? It means that Americans consume more than they actually produce.On the micro level, the only way to consume beyond ones income is to borrow from someone else to pay for the additional consumption. In other words, savings must be negative for one to consume beyond his or her income. The US is a nation of borrowers, but from whom do we borrow? China, for one…
China is a nation of “savers”, where national savings averages 50% of income. What exactly does this mean? Well, just the opposite what negative savings means; rather than consuming more than it produces, the Chinese consume only about half of what it produces. Here’s how James Fallows, a Shanghai-based journalist, explains the China/US dilemma:
Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.
What happens to the rest of China’s output? Naturally, it’s shipped overseas for Americans and others in the West to consume. The irony is that the consumption of China’s products has been kept affordable and cheap thanks to the actions the Chinese government has taken to suppress the value of the RMB, thus keeping its products cheap and attractive to American consumers.
When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.
When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).
Clearly, a strong dollar is good for America in many ways. The dollar’s strength in the last decade can be credited partially to the Chinese, who have been buying dollar denominated assets in record numbers over the last seven years.
By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion… Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world.
China’s purchase of American assets keeps demand for dollars on foreign exchange markets strong, thus the value of the dollar high relative to other currencies, allowing American firms and consumers the benefits of a strong dollars described above.
A nation’s balance of payments consists of the current account, which measures the difference between a country’s expenditures on imports and its income from exports (In 2008 China had a $232 billion current account surplus with the US, meaning the US bought more Chinese goods than China bought of American goods), and the capital account, which measures the difference between the inflows of foreign money for the purchase of real and financial assets at home and the outflows of currency for the purchase of foreign assets abroad. In the financial account, China maintains a deficit (meaning China holds more American financial and real assets than America does of China’s), to off-set its current account surplus.The two accounts together, by definition, balance out… usually. Any deficit in the China’s capital account that does not cover the surplus in its current account can be held as foreign exchange reserves by the People’s Bank of China. The PBOC, however, prefers not to hold excess dollars in reserve, as the dollar’s value is continually eroded by inflation and depreciation; therefore it invests the hundreds of billions of excess dollars it receives from Americans’ purchase of Chinese goods back into the American economy, buying up American assets, with the aim of earning interest on these assets that exceed the inflation rates.
The “assets” the Chinese are using their large influx of dollars to buy are primarily US government bonds. The government issues these bonds to finance its budget deficits, and the Chinese are happy to buy these bonds for a couple of reasons: They are secure investments, meaning that unless the US government collapses, the interest on US bonds is guaranteed income for China. That’s one reason; but the primary reason is that the purchase of these bonds puts US dollars that were originally spent by American consumers on Chinese imports right back into the hands of American consumers (via government spending or tax rebates), so they can continue buying more Chinese imports.
The Chinese demand for dollar denominated financial assets, including government bonds, corporate stocks and bonds, and real assets like real estate, factories, buildings and so on, has resulted in a long period of a strong dollar. If the Chinese ever decided to stem the flow of dollars into American assets, the dollar’s value would plummet to record lows, leading to high inflation and eventually a balancing of America’s enormous current account deficit with China and the rest of the world.
However, a falling dollar is the last thing China wants to see happen, for two reasons: One, it would make Chinese imports more expensive thus less attractive to American households, thus harming Chinese manufacturers and slowing growth in China. Two, US dollars are an asset to China. Its $1.4 billion of US debt would evaporate if the dollar took a major plunge. To China, this would represent a loss of national wealth; in effect all that “savings” that makes China so unique would disappear as the dollar dived relative to the RMB. For these reasons, it seems likely that China will continue to be a willing buyer of America’s debt, thus the financier of Americans’ insanely high consumptive lifestyle.
Discussion Questions:
Many people in America are terrified that the Chinese might dump their dollar holdings. What would happen to the value of the US dollar if China decided to change its foreign reserves to another currency?
Why is it very unlikely that China will do this? In other words, how does the status quo benefit China as well as the US?
How do American households benefit from China’s financing of the government’s budget deficits? In what way to they suffer from this arrangement?
Do you think America can continue to finance its budget deficits through the continued sale of debt to foreigners forever? Why or why not?
Milk seems like such a nice friendly product, but in New Zealand the rising cost of the essential good is getting everyone annoyed. In the past 5 years the price of dairy products in New Zealand has risen by 50%. Most assume that because of New Zealand’s comparative advantage (good weather, soils, grass growth and livestock) farmers produce milk in such great quantities that it should therefore also be cheap for consumers at the local shop. Our understanding of international trade is that it alters the domestic market, might suggest that firms who export on the global market are focused and motivated by world prices.
The NZ milk market
Fonterra is a virtual monopsony in New Zealand. This is like a monopoly except that the cooperative it is the sole buyer of raw milk products in New Zealand. It then sells 95% of its production of refined milk products to consumers around the world. The company supplies around 40% of global dairy product exports, and is by far New Zealand’s biggest company.
The world market for milk
Milk is a commodity that is traded on the international market and is traded according to the forces of world supply and world demand. These forces and the equlibrium of this market determines the world price of milk. Over the past five years more consumer globally in countries such as China, Indonesia and India have entered the middle income group and have begun to consume dairy products and feed their babies milk formula. In theory this will have likely caused a gradual shift of market demand to the left, we can also assume that as technology becomes more efficient global production has increased slowly at each price level.
The diagram above shows the link between the domestic and world markets. NZ producers milk at a low price due to the it’s comparative advantages. This means that suppliers see an attractively higher price available on the international markets. Assuming free markets NZ farmers will sell their milk products in global markets at higher prices. They therefore also charge New Zealand milk consumers the same high world price as there is no incentive to offer the quantity of milk to NZ consumers at a lower price. The main loser in the trade situation is the NZ family who has to pay more for milk. As you can also see when the world demand increases, the world price rises also forcing the NZ price to rise to NZ consumers to reduce consumption of milk. (shifting left along the demand curve)
Articles from Fonterra explain the upwards price forces currently working in the global milk market…
“Looking forward global food prices are expected to remain strong. This is not just an issue for dairy or just an issue for New Zealand. There has been a fundamental change in supply and demand for food internationally which has pushed prices to their current levels.
“While these prices are good for food exports and the New Zealand economy, New Zealanders are feeling the effects of this in their shopping trolley.
Should Fonterra morally sell milk to NZ consumers at lower prices?
Economically there is no incentive for them, but morally maybe there is and this is why the NZ government has stepped in and ordered an inquiry to how milk prices are determined. Fonterra voluntarily froze milk prices recently which seems like an odd policy from a company. Maybe firms are also motivated by factors other the profit, see comments from the above Fonterra press release here…
”We recognise milk is an important part of the diet in New Zealand and we want to ensure that future generations of New Zealanders grow up enjoying it every day. It would be great to see retailers getting in behind this commitment for the benefit of New Zealand consumers.
Fonterra Brands New Zealand Managing Director Peter McClure said: “Global price increases will continue to impact the price that dairy manufacturers like ourselves pay, however, we want milk to remain an every day part of the Kiwi diet so we’ve made a commitment to absorb any extra costs for the rest of the year.“
Morally maybe the company should offer milk at lower prices, milk is known to be a positive externality for children and adults. The company also used New Zealand’s natural resources to produce the milk. To me this is an interesting case study. Firms who trade internationally face an interesting dilemma on the impact on domestic customers but generally this is considered an acceptable downside of trade. Fonterra in NZ after much public and political pressure have gone down a different track.
Discussion Questions:
What are the determinants of world demand and supply of milk?
Describe what you think the elasticity of supply for milk would be. Are firms supply of milk more responsive or less responsive to changes in the world price?
Describe the impact of the free trade of milk by Fonterra on NZ consumers. Use the concept of consumer surplus to help describe the impact.
Assume increasing demand for milk in the long-term. Describe the effect of this change on NZ milk suppliers using the concept of producer surplus.
