Archive for the 'Exchange Rates' Category

Aug 14 2015

Marketplace explains: floating versus managed exchange rate systems

For years China has kept the value of its currency, the yuan, artificially low in order to help exporters, much to the annoyance of the countries trading partners. European and American trade authorities have called for China to abandon its managed exchange rate system, hoping that a stronger yuan would help their own manufacturers as consumers would demand less of the undervalued Chinese goods.

We’ll, this week China has begun to relax its exchange rate controls, but to the frustration of Western trade promoters, the currency has moved in the wrong direction, actually weakening against the dollar and euro.

Marketplace explains the differences between floating and managed exchange rates in the podcast below.

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Nov 27 2014

A mathematical proof of the Marshall Lerner Condition

One of the toughest topics to teach in IB higher level Economics is the Marshall Lerner Condition, which is an International Economics concept which states the following:

If the combined price elasticities of demand of a nation’s imports and exports is greater than one (PEDx + PEDm > 1), then a depreciation or a devaluation of the nation’s currency will move its current account balance towards surplus.

This is a concept I have been teaching for eight years now, and I have even written about it in my textbook and produced a YouTube video lecture explaining it to students, but one thing I’ve never done is attempted a mathematical proof of the concept (needless to say, I avoid using math as much as possible, and the prospect of “proving” the MLC was always too daunting).

But this evening I received an email from an Economics teacher in Paris asking for just such a proof. So I buckled down and worked it out. In her email, the teacher said:

The Marshall Lerner Condition states that if the PEDx + PEDm > 1 then a depreciation in a country’s currency will reduce a current account deficit.

Suppose the PED for exports = .6 and the PED for imports = .5. The sum is greater than 1, therefore the MLC is met. A depreciation of this country’s currency should therefore improve its current account balance.

But based on my analysis, this country’s current account should be getting worse, not better.

For Exports: price is decreasing but the quantity demanded is increasing by proportionally  less (since PEDx = 0.6) so the country’s total export revenue is decreasing

For Imports: price is increasing and quantity demanded is decreasing by proportionally less (since PEDm = 0.5) so the country’s total spending on imports is increasing

The country’s revenues from exports are decreasing while the country’s spending on imports are increasing, so overall the trade balance is getting worse (moving deeper into deficit) not improving.

What am I doing wrong?

This teacher’s email really stumped me at first, because her logic is totally sound. I figured the only way I was going to be satisfied was if I worked it mathematically. So here’s the result and the reply I sent to the teacher:

Hello,

Your email really got me thinking about this. Your logic stumped me at first, but then inspired me to go work it out with numbers. So, hopefully my “proof” of the MLC below will clarify your confusion.

To simplify the analysis we will use easy numbers. I will use your values of PEDx = 0.6 and PEDm = 0.5

Assumptions:

  • The US and Canada are trading partners
  • Current exchange rate: $1 US = $1 CA
  • US exports 10 widgets at $1 US apiece for a total export revenue of $10 US
  • US imports 10 wingdings at $1 CA apiece for a total import expenditure of $10 US
  • US trade balance: $10 – $10 = 0
  • PEDx = 0.6 and PEDm = 0.5

Next, assume the US $ depreciates by 10% against the CA $. Now,

  • $1 US = $0.90 CA
  • $1 CA = $1.11 US

Impact on imports:

  • Price to Americans of Canadian wingdings rises to $1.11 US
  • Quantity demanded falls by 5.5% to 9.45
  • Total expenditures on Canadian imports expressed in US $: $1.11 x 9.45 = $10.49

In order for the US trade balance to improve US export revenues must increase by more than $0.49 US.

Impact on exports:

  • Price to Canadians of US widgets falls by 10% to $0.90 CA
  • Quantity demanded increases by 6% to 10.6
  • Total revenue from exports to Canada expressed in CA $: $0.90 x 10.6 = $9.54 CA.
  • Since $1 CA = $1.11 US, the value of US exports to Canada expressed in US $ is $9.54 x $1.11 = $10.59

Expressed in US $, exports increased by $0.59 and imports increased by $0.49.

Therefore, US net exports are now $10.59 – $10.49 = $0.1. The MLC is met and the US trade balance moves into surplus.

I think the only mistake with the logic you applied in your email was that you were not considering that a country’s balance of trade is measured in its own home currency. As you can see, if we measured the value of US exports in Canadian dollars, then following the depreciation of the US dollar American export revenues actually appear to decrease, moving the US into a current account deficit. But even though Canadians are spending less of their own dollars on US goods, the Canadian dollar has now appreciated by 11%, therefore the value of US exports expressed in US $ actually increases (due to the now weaker US dollar)!

I hope this all makes sense! Thanks for inspiring me to buckle down and tackle this analysis! I’ve been teaching this concept for eight years and have never actually taken the time to walk through a proof like this.

Best,
Jason

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Nov 07 2014

The dollar’s recent rise and determinants of exchange rates – October to November 2014

In the last couple of months the exchange rate of the US dollar against the currencies of many of its trading partners has been rising steadily. The charts below show the value of the dollar in terms of Japanese Yen and Euro in the last month.

Euro per dollar Yen per dollar

 

The reasons for the rise in the dollar are simple and illustrate some of the determinants of exchange rates that we learn about in our IB Economics classes. Listen to a recent story from APM’s Marketplace radio show about the dollar’s recent rise, then answer the questions that follow.

Discussion Questions: 

  1. Discuss with your class how each of the factors mentioned in the podcast help explain the recent rise in the value of the US dollar against other major currencies:
    • “Recovery”
    • “Yields”
    • Interest rates”
  2. Why might the rising dollar…
    • help developing countries?
    • help American consumers?
    • hurt American producers?
  3. Using your knowledge of macroeconomics, discuss and explain the following claim: “the impact of more expensive exports and cheaper imports may be to stifle inflation just enough to make the Fed slow down any rate increases, which would in turn slow down the dollar’s rise.”
  4. Using diagrams for the market for US dollar in Europe and for the Euro in the United States, and referring to one of the determinants of exchange rates mentioned in the story, illustrate the rise in the dollar’s value against the Euro over the last month and the corresponding fall in the Euro’s value against the dollar. Use values from the chart above on to determine the appropriate exchange rate values for your graphs.
  5. Explain how each of the following interventions could be used to devalue the dollar, assuming the US government or Federal Reserve Bank decided the dollar’s appreciation posed a threat to the US recovery:

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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:

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?”

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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?

 

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