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:

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:

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.

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:  . 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.

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?”

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.

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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?

Feb 27 2012

## A closer look at Apple’s iPad and iPhone – “made in America”?

I have two  interesting stories on Apple and the iPad to reflect on today.

First, ABC’s Nightline recently became the first Western journalists actually welcomed into an Apple assembly plant in China. The show recently aired a 15 minute feature on working conditions inside Apple’s Foxconn factory in Shenzhen, China last week. Watch the video and then scroll down for what may be some additional surprising news about Apple’s operations in China.

Next, the story that has gone unreported lately is a University of California study titled “Capturing Value in Global Networks: Apple’s iPad and iPhone”. The study’s most interesting finding, in my opinion, is the tiny percentage of the total value of Apple’s iPhone and iPad that actually goes to the Chinese manufacturers of the products. The charts below, from the study, show how the value is divided among the various groups involved it their production and sales:

The Economist provides the analysis:

The chart shows a geographical breakdown of the retail price of an iPad. The main rewards go to American shareholders and workers. Apple’s profit amounts to about 30% of the sales price. Product design, software development and marketing are based in America. Add in the profits and wages of American suppliers, and distribution and retail costs, and America retains about half the total value of an iPad sold there. The next biggest gainers are South Korean firms like Samsung and LG, which provide the display and memory chips, whose profits account for 7% of an iPad’s value. The main financial benefit to China is wages paid to workers for assembling the product and for manufacturing some inputs—equivalent to only 2% of the retail price.

A student today asked why Apple doesn’t produce its products in the United States, where an economic downturn has left 14 million American out of work for the last three or four years. If iPads and iPhones were just made in America, jobs could be created, households would have more income to spend on Apples products, and both the country and the economy would benefit.

The data in the UC study indicates that in fact, more than half the value of an iPad or iPhone does end up in the hands of Americans. But Apple could never achieve the low costs and high profits that it does by assembling its products in the US. After watching the Nightline video above, it should be clear that the type of production involved in Apple factories’ is very low-skilled and labor-intensive. Using American labor, with its unions, minimum wages and 40 hour work weeks, would require Apple to employ such large numbers of workers and raise the company’s variable cost to such a level that the firm’s profits would be reduced significantly and its sales would fall dramatically. Apple would lose out to foreign producers of smart phones and tablet computers, such as LG, Samsung, Sony and others, which would continue assembling their goods with Chinese labor.

Ultimately, any gain to the low-skilled American workers (presuming Apple could even find enough to do the work of the 400,000 Chinese employed in the production of Apple products in China), would be offset by a loss of profits enjoyed by the millions of Americans who hold shares in Apple Computer and the thousands of American who are employed engineering and designing its products, as the firm’s sales would slip in the face of lower-cost competitors.

So this student’s question identifies an interesting paradox: America, with its large pool of unemployed workers, will never be attractive as a place to produce labor-intensive products such as phones and tablet computers, due to the vast wage differential between the US and China. And even if one firm did decide to produce its products in America, the gains to low-skilled workers who may find minimum wage work in the new assembly plants would be off-set by losses to the firms’ shareholders and the high-skilled workers whose jobs would be lost as sales decline due to the lower prices offered by lower-cost competitors.

The lesson here is two-fold: First, Apple and other American technology companies should continue using Chinese labor to assemble their products, and second, America is better off for it: lower costs mean cheaper products and higher sales, thus greater employment in the high-skilled sectors of the US economy, and more profits and returns on the investments of shareholders in American corporations. Americans are richer and enjoy a higher standard of living thanks to the millions of Chinese working in factories assembling the goods we consume.

Keep in mind, this analysis did not even consider the effect on the Chinese economy and the millions of Chinese workers (whose lives are much harder than the typical American) should companies like Apple shut down their Chinese manufacturing plants. That’s a whole other blog post!

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.

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?

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