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?

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.
• Complete three pre-readings:
  • From BizEd:
    The Marshall Lerner Condition and The Economic Effects of a Devaluation
  • From Welker’s blog: The Marshall Lerner Condition and the J-Curve
    
• 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:

1. 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)
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. (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.
3. Beneath your two new graphs, explain TWO factors that may have caused the currency to change in value. (2 marks)
4. 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:
5. 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
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. 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)
8. 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)
9. 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)

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

The $1.4 Trillion Question – James Fallows – the Atlantic

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.

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 (Zimbabwe) to the country whose trade surplus makes up the largest percentage of its GDP (Germany). 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?

CIA – The World Factbook - Iceland

How did a barren rock in the middle of the North Atlantic Ocean become one of the richest countries in the world, where the average citizen earns $40,000 per year?

Iceland’s prosperity is a perfect example of how a country that participates in international trade based on the principal of comparative advantage can produce the goods for which it has a relatively low opportunity cost, export them to the rest of the world, and become rich. Listen to the podcast below, then complete the activity that follows.

Activity:

• Go to the CIA World Factbook online.
• Look up your home country from the drop down menu.
• Click on the “Economy” section and read the introduction to your nation’s economy.
• Look through the economy section and find information on your nation’s exports, then answer the questions that follow.

Other Media Download (11)

A nation’s balance of payments measures all the transactions between the residents of that nation and the residents of foreign nations, including the flow of money for the purchase of goods and services (measured in the current account) and the flow of financial or real assets (measured in the financial or capital account). The sale of exports counts as a positive in the current account, while the purchase of imports counts as a negative. In this way, a nation can have either a positive balance on its current account (a trade surplus) or a negative balance (a trade deficit).

The US has for decades run persistent deficits in its current account. As the world’s largest importer, Americans’ appetite for foreign goods has been unrivaled in the global economy. Of course, this is not to say that the US has not been a large exporter as well. In fact, the US is also one of the largest exporting nations, along with China, Germany and Japan, in the world. However, the total expenditures by Americans on imports has exceeded the country’s income from the sale of exports year after year, resulting in a net deficit in its current account.

So the news that rising incomes in China have fueled a boom in US export sales should come as a relief to US politicians and more importantly, firms in the American export industry:

Last year, American exports to China soared 32 percent to a record $91.9 billion.

A study by a trade group called the U.S.- China Business Council says China is now the world’s fastest-growing destination for American exports.

While United States exports to the rest of the world have grown 55 percent over the past decade, American exports to China have jumped 468 percent.

Most of those exports have come from California, Washington and Texas, which have shipped huge quantities of microchips, computer components and aircraft. But states that produce grain, chemicals and transportation equipment have also benefited.

China, which last year surpassed Japan to become the world’s second largest economy (measured by total output), is soon expected to become the world’s second largest importer as well:

And while much of what China imports is used to make goods that are then re-exported, like the Apple iPhone, Mr. Brasher says a growing share of what China imports from the United States, including cotton and grain as well as aircraft and automobiles, is staying in China.

“You know all those BMW X5 S.U.V.’s that are in China? They’re being imported from the U.S.,” Mr. Brasher said in a telephone interview Thursday. “They’re being made by a BMW factory in South Carolina.”

All this must be good news for the US, right? Growing exports to China must mean a smaller current account deficit, greater net exports and thus stronger aggregate demand, more employment and greater output in the United States. However, this may not be the case. While exports to China grow, the US economy’s recovery has led to a boost in the demand for imports from China as well. So, ironically, even as exports have grown 468 percent in the last decade, the US has still managed to maintain a stunningly large trade deficit with China: 

Last year, China’s trade surplus with the United States was between $180 billion or $250 billion, according to various calculations.

Still, the combination of a weakening American dollar and China’s growing economic clout is likely to bode well for American exports. With China short of water and arable land, exports of crops to China jumped to $13.8 billion last year.

Study the graph below and answer the questions that follow.

Discussion Questions:

1. What is the primary determinant of demand for exports that has lead to the growth over the last decade seen in the graph above?
2. What types of goods has China primarily imported from the US in the past? As incomes in China rise, how will the composition of its imports from the US likely change?
3. How is it possible that the US current account deficit remains as large as it does (as much as $250 billion) despite the growth in exports to China?
4. The value of China’s currency, the RMB, is closely managed by the Chinese Central Bank to maintain a low exchange rate against the US dollar. How does maintaining a low value of its currency exacerbate the imbalance of trade between China and the US? How would allowing greater flexibility in the RMB’s value help reduce the large imbalance of trade between the two countries?
5. If the US spent $250 billion more on Chinese goods than China did on US goods in 2010, where did that $250 billion end up? What does China do with the money the US spends on its goods that it does not spend on US goods? Define the financial account and explain the relationship between a nation’s current account balance and its financial account balance.

Should President Obama consider writing a thank you note to Chinese leaders for artificially manipulating the Chinese Yuan in the foreign currency markets?

For many years now, Chinese authorities have artificially intervened in the foreign currency market by buying up U.S. dollars spent on Chinese products and, in turn, investing those same U.S. dollars in U.S. Treasury Securities (ie, bonds and notes). For those that are not familiar with the foreign currency market, Chinese authorities buy the same U.S. Dollars provided by the U.S. to purchase Chinese products and, thus, leave or supply Chinese Yuan to the currency traders resulting in a decrease in the price of the now more plentiful Yuan and an increase in the price of the now more scarce dollar.  The Chinese authorities intervene in the foreign currency market for the sole purpose of depreciating (weakening) the Yuan relative to the U.S. Dollar, thereby helping Chinese exporters to become more price competitive in global markets. It is estimated by many economists, that the Yuan may be overvalued versus the U.S. dollar by approximately 30% due to this foreign currency intervention by China.

So while it is true that this action taken by Chinese authorities clearly depreciates the Yuan and appreciates the Dollar, thus, unfairly harming U.S. exporters; it is also hitting the “sweet spot” by sending those same U.S. dollars back to the U.S. Government to fund the record federal deficit spending expecting to total $1.3T in 2011 and providing American citizens with reduced prices on imports via the stronger dollar! More specifically, this currency intervention by Chinese authorities provides needed loanable funds back to the U.S. Government lowering borrowing costs or interest rates during this important U.S. economic recovery time. It also appears that US leaders are sending mixed messages to China as just last year, Secretary of State Hillary Clinton visited Beijing to encourage Chinese leaders to continue to purchase U.S. Government securities. This seems at odds with US officials cry for China to stop intervening in the foreign currency markets because by doing so needed federal deficit funding would dry up from the Chinese, forcing the US to borrow elsewhere and raise interest rates to entice that lending.

In summary, perhaps in the short term the United States should consider not pressuring China, as Treasury Secretary Tim Geihtner, Obama and the media have done regularly. Perhaps US officials should lay low, at least for awhile, and start pressuring the Chinese again in about three or four years, after the Government’s budget no longer calls for such large spending deficits.

Review Questions

1. What specifically are Chinese leaders doing to keep the Yuan weak against the U.S. dollar?
2. Why are Chinese leaders intervening in the foreign currency market?
3. Which parties, both American and Chinese, are helped and hurt by this intervention?
4. What would happen, other things equal to U.S. interest rates if Chinese authorities immediately stopped intervening in the currency market? Why?
5. What would be the immediate impact on the U.S. poor and working class if the Chinese immediately stopped intervening in the currency market?
6. What policy position would you take as President of the United States on this issue?

FT.com / Asia-Pacific – Renminbi at heart of trade imbalances.

“The Americans get the toys, the Chinese get the Treasuries and we get screwed.” Thus a European Union official once characterised the pattern of Beijing accumulating US assets by selling renminbis for dollars, while nothing stood in the way of a rapid and destabilising appreciation of the euro.

In a world of freely floating exchange rates trade imbalances between countries would ultimately be reduced and eliminated. At least, that’s the belief of those advocating a floating exchange rate between East Asian currencies and the United States.

Here’s how it is supposed to work:

• Cheap labor and cheap imports from China following China’s joining the world economy 30 years ago led to a rapid increase in demand for Chinese manufactured goods in the US, creating growth, jobs, and rising national income for China.
• A trade imbalance emerges between the US and China as US spending on imports increases more rapidly than America’s  sale of exports. If the Chinese currency were allowed to float freely on foreign exchange markets, however, this imbalance would be temporary, because…
• The US current account deficit means, literally, that Americans are supplying more of their dollars in the foreign exchange market, while demanding more Chinese RMB. The forces of supply and demand would naturally lead to an appreciation of the RMB and a depreciation of the dollar.
• The weaker dollar resulting from the trade deficit with China would eventually make Chinese goods less attractive to Americans. Despite their lower costs of production, the weak dollar makes imported Chinese goods more expensive and less appealing to the American consumer.
• The strong RMB, on the other hand, makes American produced goods and services cheaper to Chinese consumers, who begin to import more from the US at the same time that Americans demand fewer of China’s products.
• Through free-floating exchange rates, a current account imbalance is eventually reduced and eliminated as exchange rates adjust to the flows of goods and services between trading partners.

A graphical version of this story is told here:

This, of course, is precisely what has NOT happened, thanks to China’s strict management of the value of the RMB. In order to keep its currency weak, Beijing directly intervenes in foreign exchange markets, “by selling renmenbi for dollars” to accumulate American assets. As seen in the next graph, such interference has the effect of keeping the dollar strong against the RMB.

As any IB student knows, the Balance  of Payments between two countries includes not only the trade in goods and services, but also the flow of real and financial assets, such as government securities, stocks, real estate, factories, and so on, between the countries. China has actively promoted a policy of acquiring such American assets, which keeps demand for dollars strong in China, and supply of RMB high in America, without creating any jobs in manufacturing or services for Americans. China has financed America’s current account deficit by assuring it maintains a capital account surplus!

Put more simply, China has exported goods and services to America, while America has exported ownership of its real and financial assets to China. This is a major area of concern for US policy makers, who would like to see a more balanced current account between the two countries, since it is the export of goods and services that creates jobs for American workers, not the sale of bonds, stocks and real estate.

Discussion Questions:

1. Why does Europe care about China’s fixed exchange rate with the US dollar?
2. Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
3. Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
4. How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?

The following is an excerpt from Chapter 22  - “Balance of Payments” of my soon to be published textbook “Pearson Baccalaureate Economics”

If the total spending by a nation’s residents on goods and services imported from the rest of the world exceeds the revenues earned by the nation’s producers from the sale of exports to the rest of the world, the nation is likely experiencing a current account deficit. The situation is not at all uncommon among many of the world’s trading nations. The map belowmap  represents nations by their cumulative current account balances over the years 1980-2008. The red countries all accumulated current account deficits over the three decades, with the largest by far being the United States with a cumulative deficit of $7.3 trillion. The green countries are ones which have had a cumulative surplus in their current accounts, the largest surplus belonging to Japan at $2.7 trillion, followed by China at $1.5 trillion.

source: http://en.wikipedia.org/wiki/File:Cumulative_Current_Account_Balance.png

The top ten current account deficit nations are represented below. It is obvious from this chart that the United States alone accounts for a larger current account deficit then the next nine countries combined. At $7.3 trillion dollars in deficits over 28 years, the US deficit surpasses Spain’s (at number 2) by 1,000 percent.

The consequences of a nation having a current account deficit are not immediately clear. It should be pointed out that it is debatable whether a trade deficit is necessarily a bad thing, in fact. Below we will examine some of the facts about current account deficits, and we will conclude by evaluating the pros and cons for countries that run deficits in the short-run and in the long-run.

Implications of persistent current account deficits: When a country like like those above experience deficits in the current account for year after year, there are some predictable consequences that may have adverse effects on the nation’s macroeconomy. These include currency depreciation, foreign ownership of domestic assets, higher interest rates and foreign indebtedness.

The effect of a current account deficit on the exchange rate: In the previous chapter you learned about the determinants of the exchange rate of a nation’s currency relative to another currency. One of the primary determinants of a currency’s exchange rate is the demand for the nation’s exports relative to the demand for imports from other countries. With this in mind, we can examine the likely effects of a current account deficit on a nation’s currency’s exchange rate. Additionally, we will see that under a floating exchange rate system, deficits in the current account should be automatically corrected due to adjustments in exchange rates.

When households and firms in one nation demand more of other countries’ output than the rest of the world demands of theirs, there is upward pressure on the value of trading partners’ currencies and downward pressure on the importing nation’s currency. In this way, a movement towards a current account deficit should cause the deficit country’s currency to weaken.

As an illustration, say that New Zealand’s imports from Japan begin to rise due to rising incomes in New Zealand and the corresponding increase in demand for imports. Assuming Japan’s demand for New Zealand’s output does not change, New Zealand will move towards a deficit in its current account and Japan towards a surplus. In the foreign exchange market, demand for Japanese yen will rise while the supply of NZ$ in Japan increases, as seen above, depreciating the NZ$.

The downward pressure on exchange rates resulting from an increase in a nation’s current account deficit should have a self-correcting effect on the trade imbalance. As the NZ$ weakens relative to its trading partners’ currencies, consumers in New Zealand will start to find imports more and more expensive, while consumers abroad will, over time, begin to find products from New Zealand cheaper. In this way, a flexible exchange rate system should, in the long-run, eliminate surpluses and deficits between nations in the current account. The persistence of global trade imbalances illustrated in the map above is evidence that in reality, the ability of flexible exchange rates to maintain balance in nations’ current accounts is quite limited.

Foreign ownership of domestic assets: By definition, the balance of payments must always equal zero. For this reason, a deficit in the current account must be offset by a surplus in the capital and financial accounts. If the money spent by a deficit country on goods from abroad ends up in the does not end up returning to the deficit country for the purchase of goods and services, it will be re-invested into the county through foreign acquisition of domestic real and financial assets, or held in reserve by surplus nations’ central banks.

Essentially, a country with a large current account deficit, since it cannot export enough goods and services to make up for its spending on imports, instead ends up “exporting ownership” of its financial and real assets. This could take the form of foreign direct investment in domestic firms, increased portfolio investment by foreigners in the domestic economy, and foreign ownership of domestic government debt, or the build up of foreign reserves of the deficit nation’s currency.

The effect on interest rates: A persistent deficit in the current account can have adverse effects on the interest rates and investment in the deficit country. As explained above, a current account deficit can put downward pressure on a nation’s exchange rate, which causes inflation in the deficit country as imported goods, services and raw materials become more expensive. In order to prevent massive currency depreciation, the country’s central bank may be forced to tighten the money supply and raise domestic interest rates to attract foreign investors and keep demand for the currency and the exchange rate stable. Additionally, since a current account deficit must be offset by a financial account surplus, the deficit country’s government may need to offer higher interest rates on government bonds to attract foreign investors. Higher borrowing rates for the government and the private sector can slow domestic investment and economic growth in the deficit nation.

Side note: While the interest rate effect of a large current account deficit should be negative (i.e. causing interest rates to rise in the deficit country), in recent years the country with the largest trade deficit, the United States, has actually experienced record low interest rates even while maintaining persistent current account deficits. This can be understood by examining by the macroeconomic conditions of the US and global economies, in which deflation posed a greater threat than inflation over the years 2008-2010. The fear of deflation combined with low confidence in the private sector among international investors has kept demand for US government bonds high even as the US trade deficit has grown, allowing the US government and central bank to keep interest rates low and continue to attract foreign investors.

Whereas under “normal” macroeconomic conditions a build up of US dollars among America’s trading partners would require the US to raise interest rates to create an incentive for foreign investors to re-invest that money into the US economy, in the environment of uncertainty and low confidence in the private sector that has prevailed over the last several years, America’s trading partners have been willing to finance its current account deficit at record low interest rates.

The effect on indebtedness: A large current account deficit is synonymous with a large financial account surplus. One source of credits in the financial account is foreign ownership of domestic government bonds (i.e. debt). When a central bank from another nation buys government bonds from a nation with which it has a large current account surplus, the deficit nation is essentially going into debt to the surplus nation. For instance, as of August 2010, the Chinese central bank held $868 billion of United States Treasury Securities (government bonds) on its balance sheet. In total, the amount of US debt owned by foreign nations in 2010 was $4.2 trillion, or around 50% of the country’s total national debt and 30% of its GDP.source: http://www.ustreas.gov/tic/mfh.txt

On the one hand, foreign lending to a deficit nation is beneficial because it keeps demand for government bonds high and interest rates low, which allows the deficit country’s government to finance its budget without raising taxes on domestic households and firms. On the other hand, every dollar borrowed from a foreigner has to be repaid with interest. Interest payments on the national debt cost US taxpayers over $400 billion in 2010, making up around 10% of the federal budget. Nearly half of this went to foreign holders of US debt, meaning almost $200 billion of US taxpayer money was handed over to foreign interests, without adding a single dollar to aggregate demand in the US.

The opportunity cost of foreign owned national debt is the public goods and services that could have been provided with the money that instead is owed in interest to foreign creditors. If the US current account were more balanced, foreign countries like China would not have the massive reserves of US dollars to invest in government debt in the first place, and the taxpayer money going to pay interest on this debt could instead be invested in the domestic economy to promote economic growth and development.

Discussion Questions:

1. Why would a large current account deficit cause a nation’s currency to depreciate? How could a weaker currency automatically reduce a nation’s current account deficit?
2. Why should governments be concerned about a large trade deficit? What is one policy a government could implement to reduce a deficit in the current account?
3. Would a nation with a large trade deficit be better off without trade at all? Why or why not?
4. Discuss the validity of the following claim: “Americans buy tons of Chinese imports, but the Chinese don’t buy anything from America, this is why the US has such a huge trade deficit with China”. To what extent is this claim true or false?

When teaching international trade to high school economics students, one of the challenges is understanding the pros and cons of trade surpluses and deficits. A country’s balance of trade refers to the net flow of revenues and expenditures goods and services between the country and its trading partners. In technical terms, this is known as the current account on a nation’s balance of payments. A country that spends more on imports than it earns from the sale of exports has a current account deficit. A nation that earns more from the sale of its goods and services to the rest of the world than it spends on imports has a current account surplus.

A common impressions among students is that a trade surplus is good and a trade deficit is bad. One challenge I face in teaching this topic is separating economic terms such as “suplus” and “deficit” from non-economic, normative concepts such as “good” and “bad”. In fact, a trade surplus is not always a good thing. To illustrate, I will look at the current account balances between China and the United States. In 2007, the US ran a trade deficit with China of $258 billion. While the US imported $321 billion of Chinese goods and services, it only earned $63 billion from the sale of exports to China. To most students, it would appear that China is “winning” in the game of trade, since it has such an enormous trade surplus with the United States. This, however, is not necessarily the case.

One way of looking at trade balances is that a nation with a substantial current account surplus is actually consuming less of its own output due to the high demand from abroad. As mentioned above, in 2007 Americans spent $321 billion on Chinese goods and services. China only produced $3.2 trillion of goods and services that year, meaning Americans actually consumed over 10% of the stuff produced in China! This represents Chinese output that is NOT being consumed by the Chinese. Additionally, since China imported far less from abroad than it sold, Chinese output being consumed abroad is far from made up for by Chinese consumption of foreign output. While this may sound like a good deal from the perspective of producers, who have a larger market due to trade, from the perspective of Chinese households it means they are consuming less than they are producing as a nation!

One of the goals of macroeconomics is to increase the standards of living of the nation’s people through an increase in the consumption of goods and services. In this regard trade deficit countries are actually better off than trade surplus countries, since they are actually consuming MORE than they are producing as a nation! A trade deficit country gets more than it gives, in a way, which sounds pretty good when if you consider total consumption to be an end in itself. A trade surplus country, on hte other hand, gives the rest of the world more than it gets in return (in terms of goods and services, that is).

Another consequence of running a large trade surplus is the build up of foreign exchange reserves. China, for instance, held over $1.3 trillion USD in its central bank in 2007, representing an enormous level of savings for the Chinese people, since these are dollars earned by the people of China (from their export sales to America), but not spent. These reserves represent a form of forced savings on the people of the nation.

The average Chinese consumer is also made worse off because the governments’ US dollar reserves are held intentionally to keep the value of the dollar high, thereby keeping the price of American and other nation’s imports prohibitively high for Chinese consumers. In this regard, China’s 50% national savings rate is a form of financial tyranny by the government perpetrated against the Chinese people, who, as consumers, would be much better off if the RMB were allowed to appreciate and imported goods and services could be more easily and affordably attained by Chinese households. Employment in the export sector might suffer but falls in exports would likely be made up for with gains in domestic consumption, meaning the overall effect on employment is likely to be mild upon a reductions in China’s trade surplus.

Furthermore, in order to maintain China’s trade surplus the Chinese government must keep the RMB weak. As already mentioned, one way it does this is by holding its US dollar reserves to keep the supply of dollars on foreign exchange markets low and its value high. Another way the Chinese central bank manipulates its currency is by constantly changing the level of interest rates to limit or encourage foreign capital flows into or out of the country, since such flows affect the Chinese currency’s value. If the Chinese central bank and government were to adopt a flexible exchange rate policy, which would help reduce the country’s trade surplus with the United States, this would allow the central bank to use monetary policy in the way it is meant to be used: to stimulate or contract the level of domestic consumption and investment. This week US Fed chairman Ben Bernanke spoke to the US Senate about China’s exchange rate controls, and made a similar point:

“Most economists agree the Chinese currency is undervalued and has been used to promote a more export-oriented economy. I think it would be good for the Chinese to allow more flexibility in their exchange rate.”

Letting its currency, the renminbi, appreciate would give China’s central bank more flexibility in monetary policy and help stimulate domestic demand and consumption, Mr. Bernanke said

China’s trade surplus does not necessarily benefit the country as a whole. Surpluses do keep export sector employment high, but result in a lower overall level of consumption among Chinese households and impose a higher than necessary level of savings on the nation. More balanced trade would increase the level of imported goods and services in China, increase real incomes as the value of the nation’s currency rises, and also allow for more inflows of foreign capital from abroad, further stimulating growth in China’s domestic economy.

Discussion Questions:

1. What are the advantages and disadvantages for the United States of its large current account deficit?
2. What are the advantages and disadvantages for China of its large current account surplus?
3. What benefits would China experience if its currency, the RMB, appreciated against the dollar? What negative consequences would this have for China?
4. Why does China’s large holdings of US dollars and US government debt represent a form of “forced saving” imposed by the Chinese government on the people of China?
5. Would you rather live in a country with a current account surplus or a current account deficit? Why?

One feature of Economics in Plain English several students and teachers have found helpful over the years is the Econ Help Desk, where readers can get questions about basic economic concepts answered personally by me.

Recently I received the following email from an AP Macroeconomics teacher in the United States:

I have a question about graphs that illustrate how trade preferences (specifically Supply and Demand shifts), affect P, Q and Pe on Supply-Demand GRAPHS of Currency Exchange.

In teaching my AP Macro students about this concept, I have reached a gap in our full understanding how to graph the Supply and Demand of Yen, or Euro (Price in USD).

For example, if the Price levels rise in the U.S., relative to Japan’s, and consequently, the U.S. demands more Japanese cars and stereos, the only label that we ever see for the x-axis is “Q” or Quantity, or Qe, a vertical line that represents the starting “market clearing price”, of .01USD=1Y. When DEMAND or SUPPLY shifts, the only change that I ever see labeled on the graphs is the Y-Price in USD of Yen, but descriptions simply talk about the Y=1.

When Demand or Supply shifts (in response to increased demand for Yen), and there is a new higher or lower USD Price for Yen, respectively, does the vertical line for Q simply shift outward (continuing to represent Y=1) at whatever the new Price Equilibrium becomes (simply meaning just more “1s” of them in circulation (at each new Pe market-clearing point)?

Thanks

Here is my response:

Hello, I will try to address your questions below.

Exchange rates can be determined by several factors, including relative price levels, relative interest rates, tastes and preferences of domestic and international consumers, relative income levels at home and abroad and speculation by currency traders. As you say, an increase in the price level of goods produced in United States (say, Fords), ceteris paribus, should lead to an increase in demand among American consumers for goods produced in Japan (say, Hondas), which now appear relatively cheaper. Demand for Yen increases among American households who wish to buy Japanese goods. The USD price of Yen then rises in the Yen market. Since Japanese holders of Yen now receive more USD for each Yen, they will provide more Yen (this is another way of saying with an increase in demand for Yen, the quantity supplied of Yen increases).

Theory would say that there is no increase in the supply of Yen following an increase in Demand by American consumers, only an increase in quantity supplied. The Yen clearly appreciates, as the USD/Yen exchange rate rises. Now, there is another side to this story. The Yen market refers to the market for Yen in the United States. Yen will appreciate in the United States. Simultaneously, USD will depreciate in Japan, as Americans buy more Japanese goods, they are supplying more USD in the USD market in Japan. Here the “price” or the exchange rate is Yen/USD. The Yen price of a USD will fall as the supply of USD increase as Americans exchange their dollars for Yen to buy the relatively cheap Japanese goods.

The “market-clearing price” in forex markets is the exchange rate that prevails in a floating exchanged rate system where exchange rates are determined solely by supply and demand by international consumers, investors, government, banks, and firms. Assume the Yen is trading for $0.01. If , following inflation in the United States and the corresponding increase in demand for Yen, the value of the Yen remained at $0.01, then the quantity demanded for Yen would exceed the quantity supplied. There would be shortages of Japanese goods in the United States, as Japanese goods are in greater demand yet their prices have not risen. In order to “clear the market” so to speak, the exchange rate must rise, to say $0.012. Now, a Yen’s worth of goods “costs” Americans 20% more than previous, making them less attractive over time. Likewise, a dollar’s worth of goods “costs” Japanese consumers 20% less, since the dollar is weaker in Japan.

As you can foresee, the floating value of the Yen should lead to relatively balanced trade between Japan and the US. The US current account will initially move towards deficit as inflation makes American goods more expensive, however, as demand for Japanese goods increases, the value of the Yen rises making Japanese goods more expensive, which will eventually reduce their appeal to American consumers who will once again begin consuming more American goods and importing less. Japanese will notice the weaker dollar makes US imports cheaper and begin importing more American products. The US current account should remain  balanced in the long-run in a floating exchange rate system.

I don’t know if you’ve had a look at my study guides on exchange rates and balance of payments, but those may help clarify graphically what I describe above:

• Unit 4: Exchange Rates
• Unit 4: Balance of Payments

I hope this clarifies your understanding of how relative price levels help determine exchange rates!

Best,
Jason