Archive for the 'Balance of Payments' Category

Feb 07 2013

Lesson plan: Elasticity, exchange rates and the balance of payments – understanding the Marshall Lerner Condition

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:

  1. Define ‘price elasticity of demand’ and explain how it is measured.
  2. 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
  3. Explain how the depreciation of a country’s exchange rate might affect its current account balance. IS THIS ALWAYS THE CASE?
  4. 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?

Part 1:

  • 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.
  • Complete three pre-readings:
  • 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:

Take a snapshot of your two-year exchange rate diagram in OneNote, then copy and paste the questions below into the page.

Questions to answer in OneNote:

  1. Write a brief description of the changes in your country’s exchange rate over the last two years. (2 marks)
  2. 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. Highlight these in two different covers in your graph.
  3. Describe what is happening to your currency during the two time periods you highlighted in your chart. (2 marks)
  4. Explain TWO factors that may have caused the currency to change in value. (2 marks)
  5. 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. Following appreciation – in the short-run and in the long-runFollowing depreciation – in the short-run and in the long-run. (4 marks)
  6. 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)
  7. 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)
  8. 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

Part 2:

Read the following article:  How Far Will the Dollar Fall?’ by Richard W. Rahn. Based on the extracts below, answer the questions that follow.

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)

The above lesson was inspired by the Biz-Ed activity “International Trade: The Falling Dollar or Rising Pound?”

4 responses so far

Mar 06 2012

Planet Money Podcast – “China’s Giant Pool of Money”

NPR’s Planet Money team did a great podcast last week about China’s accumulation of US dollars from its large trade surplus with the United States. This story offers a great illustration of the theories I introduced in my recent video lesson, The Relationship between the Current Account Balance and Exchange Rates

Listen to the podcast, watch the video lesson, and respond to the discussion questions that follow.

Discussion Questions:

  1. Why does the Chinese Central Bank possess over $3 trillion of foreign exchange reserves?
  2. What does the Chinese Central Bank do with the vast majority of the money it earns from the sale of its exports that it does NOT spend on US goods? Why not keep this money in cash?
  3. Why does the Chinese Central Bank manage the value of its currency, the RMB? Why not let the exchange rate be determined by the free market?
  4. As the RMB is slowly strengthened against the dollar, who are the winners and losers? What impact should a stronger RMB have on the balance of trade between China and the US?


One response so far

Feb 10 2012

The source of America’s trade deficit with China

I’m showing the PBS documentary, “Is Walmart Good for America?” to my AP Macroeconomics students today as we introduce the topic of trade balances.

Discussion questions will be posted soon.

No responses yet

Nov 07 2011

Excuse me, China… could you lend us another billion? Understanding the imbalance of trade between China and the United States

The $1.4 Trillion Question – James Fallows – the Atlantic

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:
  1. 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?
  2. 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?
  3. How do American households benefit from China’s financing of the government’s budget deficits? In what way to they suffer from this arrangement?
  4. Do you think America can continue to finance its budget deficits through the continued sale of debt to foreigners forever? Why or why not?

152 responses so far

Oct 31 2011

Trade balances around the world

The table below shows the trade balances for the nations from which my year two IB Economics student come. They are ranked in order from the country whose trade deficit makes up the largest percentage of its GDP  to the country whose trade surplus makes up the largest percentage of its GDP. The blue bars represent the value of the deficit or surplus of each nation. As can be seen, Zimbabwe’s trade deficit is very small in dollar terms, but since its economy is also very small this deficit makes up a large percentage of its total GDP. Click on the image to visit an interactive version of the chart on which you can study the data more closely. Then answer the questions that follow.
Discussion Questions:

  1. Identify and define the four components of an nation’s current account balance.
  2. According to the data, which three countries are the most import dependent? Which three countries are the most export dependent? Which country has the most balance trade in goods and services? Which has the most imbalanced trade?
  3. If your country is one of deficit countries above, answer the following two questions:
    1. Assuming its currencies’ exchange rates is floating, explain how persistent current account deficits will affect a country’s exchange rate over time?
    2. Summarize and explain the likely effects of a current account deficit on the following: a) the financial account balance, b) domestic interest rates, and c) national debt.
  4. If your country is one of the surplus countries above, answer the following two questions:
    1. Assuming its currencies’ exchange rates is floating, explain how persistent current account surpluses will affect a country’s exchange rate over time?
    2. Summarize and explain the likely effects of a current account surplus on the following: a) domestic savings rates, b) the financial account balance.
  5. What are the various methods a country can take to reduce a current account deficit? What is the benefit of having a balanced current account as opposed to a large deficit or surplus?

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