Archive for the 'Current account' Category

May 12 2009

Deteriorating terms of trade and the current account balance

U.S. Trade Gap Widens on Oil Imports –

Terms of trade is a term that is often misunderstood by IB Economics students. Simply put, a nation’s terms of trade refers to the relative price of a country’s exports to its imports.

When a country’s imports increase in price, while the value of its exports stays the same, the country’s terms of trade are said to deteriorate. As a nation experiences deteriorating terms of trade, it finds itself moving towards a deficit in its current account, meaning that expenditures on imports are growing more than income from exports, also called a trade deficit.

The United States has run trade deficits for most years since 1970. Since 2004 the US has annually spent over $600 billion MORE on imports than it earned from the sale of its exports. (Balance of trade data going back to 1960 can be found here).

Usually, when a country enters a recession, it would be expected that its balance of trade would improve, since households demand fewer imports and domestic inflation decreases making the country’s products more attractive to foreign households. In fact, in 2008, when the US entered its current recession, its trade deficit actually decreased. Recently, however, due to the weakness of many of its trading partners and a deterioration in terms of trade, America’s recession is accompanied by a deepening trade deficit:

The U.S. trade deficit widened for the first time in eight months during March, as the price and use of imported oil both climbed.

The U.S. deficit in international trade of goods and services increased to $27.58 billion from February’s revised $26.13 billion, the Commerce Department said Tuesday. Originally, the February deficit was estimated at $25.97 billion.

U.S. exports in March slipped by 2.4% to $123.62 billion from $126.63 billion as trading partners bought less consumer goods and cars from the U.S. U.S. imports fell at a lower rate, dropping 1.0% to $151.20 billion from February’s $152.76 billion

Discussion Questions:

  1. How did rising oil prices lead to an increase in America’s trade deficit?
  2. What determines demand for American exports in the rest of the world? Why is demand for American goods and services falling even as their prices decline due to deflation in the US?
  3. Where does America get the money to buy hundreds of dollars more in imports than it sells in exports? What do foreigners do with all the US dollars they earn from their enormous trade surplus with the US?
  4. Why doesn’t the US government simply place tariffs or quotas on imports to try and achieve more balanced trade with the rest of the world? Is this an appropriate response to a trade deficit?

6 responses so far

Dec 12 2008

The Marshall-Lerner Condition, the J-curve, and the US trade deficit

For a video lesson on the Marshall Lerner Condition and the J-curve, click here: The Marshall-Lerner Condition (HL Only) | The Economics Classroom

Read the following article before reading the blog post below:
Managing Globalization » Business Blog » International Herald Tribune » Blog Archive » Here’s that silver lining, finally

In IB Economics we’ve been studying concepts relating to balance of trade and exchange rates. The Marshall-Lerner Condition and the J-curve are two concepts that explain the relationship between a the exchange rate for a nation’s currency and the country’s balance of trade. (click on the graph to see a larger version)

Common sense might indicate that if a country’s currency (let’s say the US dollar) depreciates relative to other currencies, then this should lead to an improvement in the country’s balance of trade (economists call this the current account). The reasoning goes as such: a weaker dollar means foreigners will have to give up less of their money in order to get one dollar’s worth of American output. At the same time, since the dollar is worth less in foreign currency, imports become more expensive, as Americans have to fork over more dollars for a certain amount of another country’s output; hence, imports should decrease.

Fewer imports and more exports means an improvement in the country’s balance of trade, right? Well, not necessarily. What matters is not whether a country is importing less and exporting more, rather, whether the increase in income from exports exceeds the decrease in expenditures on imports. Here is where the Marshall-Lerner Condition can be applied.

The M-L condition examines the price elasticities of demand for exports and imports of a particular country. Say the US experiences a depreciation of its currency (as it has over the last year or so). If foreigners’ demand for exports from America is relatively elastic, then a slightly weaker dollar should cause a dramatic increase in foreign demand for American output, causing export income in the US to rise dramatically. On the other hand, if American’s demand for imports is highly price elastic, then a slightly weaker dollar should likewise cause Americans’ demand for imports to decrease drastically, reducing greatly American’s expenditures on imports. If the combined elasticities of demand for exports and imports is elastic (i.e. the coefficient is greater than 1), then a depreciation of a nations currency will shift its current account towards surplus. This is the Marshall-Lerner Condition.

Marshall-Lerner Condition: If PEDx + PEDm > 1, then a depreciation or a devaluation of a nation’s currency will shift the the balance on its current account towards surplus.

So what if the Marshall Lerner Condition is not met? Demand for exports and imports may not always be so responsive to changes in exchange rates. Imagine a scenario where a weaker dollar does little to change foreign demand for America’s output. In this case income from exports may actually decline (in real terms, since the dollar is weaker) as the dollar depreciates. Likewise, if Americans’ demand for imports is highly inelastic, then more expensive imports will only minimally affect Americans’ demand for imported goods, in which case expenditures on imports may actually rise as they become more expensive. In this case, where the elasticities of demand for exports and imports are highly inelastic, a depreciation of the currency will actually worsen a trade deficit. Americans’ import expenditures will go up while export income from abroad will decline shifting the current account further into deficit.

In the article above, some data is presented that points to evidence that in the US today, the Marshall-Lerner Condition is in fact being met:

“Exports in the year through September are up by 12 percent from 2006, while the dollar’s trade-weighted exchange rate dropped by only 6 percent. That means foreigners may actually be spending more – even in their own currencies – on American products. It’s a support that the American economy, and in turn the global economy, can really use right now.

Of course, this process isn’t helping the trade deficit too much, No one, it seems, can change Americans’ taste for foreign products. But it does show, for all to see, that the risks of an open economy are at least somewhat balanced by the benefits.”

An increase in exports of 12% in response to a 6% weakening of the dollar indicates a price elasticity of demand coefficient for America’s exports of 2, meaning foreigners are highly responsive to cheaper US goods.

We can assume that Americans’ demand for imports is highly inelastic, as the article hints at when it says, “imports to the United States, including oil, are still rising in volume and value.” If a 6% weaker dollar leads to an increase in expenditures on imports, then demand must be less than one. In order for M-L Condition to be met, PEDx+PEDm must be greater than 1. Clearly, with a PEDx of 2, the condition is met, and a weaker dollar in leading to an improvement in America’s balance of trade with the rest of the world.

Discussion Questions:

    1. What is the J-curve effect? Based on the evidence from the article, where on the J-curve is the US right now?
    2. Is America experiencing an improvement in or a worsening of its current account deficit?
    3. What determinants of demand are fueling America’s ever-increasing expenditures on imports?
    4. What should happen to the elasticity of demand for imports if the dollar remains weak in the long-run? How will this affect America’s position on the J-curve?


119 responses so far

Dec 10 2008

Big trouble in little China – how slowing growth may mean major problems for the Chinese Communist Party

How high is China’s jobless rate? | The great wall of unemployed | The Economist

China Faces Unemployment Woes

Unemployment in China is a big deal. The legitimacy of the Chinese Communist Party hinges on its ability to assure  stable jobs and income growth for the 300 million “middle class” Chinese who live in the country’s cities. When the urbanites are unhappy, trouble ensues.

So a dip in economic growth rate into single digits, while we in the West may think of it as silly to fret about, is a major deal for China. Interestingly, according to the Economist newspaper, unemployment data in China is notoriously unreliable; in fact analysts have no clear idea of just how much unemployment there is:

Until the 1990s, the government more or less guaranteed full employment by providing every worker with an “iron rice bowl”—a job for life. But when soaring losses at state-owned firms forced the government to lay off about one-third of all state employees between 1996 and 2002, the official unemployment rate rose only slightly. Today it is 4% in urban areas, up from 3% in the mid-1990s.

But the official rate excludes workers laid off by state-owned firms. Thus at the start of this decade, when lay-offs peaked, it hugely understated true unemployment. Over time, as laid-off workers have found jobs or left the labour force, the distortion will have shrunk. Another flaw is that the official unemployment statistics cover only people who are registered as urban dwellers. An estimated 130m migrant workers have moved from the country to the cities, but there is no formal record that they live there, so they are ignored by the statisticians. After adjusting the official figures for these two factors, several studies earlier this decade concluded that the true unemployment rate was above 10%—and might be even as high as 20%.

The textbook definition of unemployment is the percentage of the labor force actively seeking but unable to find a job. In China, however, the “labor force” only includes the 25% of the country’s population that lives in cities, and the massive number of workers who were fired from state-owned enterprises over the last decade are mysteriously excluded from official figures. 4% unemployment, the official number, puts most developed countries to shame, as it represents extremely low levels of unemployment.

Despite the fuzziness in the figures, one thing is for sure, slower economic growth, even though it is still expected to be between 8-9% this year, means fewer new jobs in China, hence the government’s recent slashing of interest rates to re-invigorate investment and spending in the economy.

…on November 26th the People’s Bank of China slashed rates by more than a percentage point—the most in 11 years—to boost growth. The slowing economy has led factories to cut jobs, and there are mounting fears that the swelling ranks of the unemployed might one day take to the streets and disrupt China’s economic miracle.

An interesting point made in this article is that even continued economic growth in China does not guarantee continued job growth. Basic economic theory holds that when a nation’s output is increasing, employment is also increasing, since growth in output implies increase demand for labor. China, however, is experiencing a different type of growth today than that of years past:

China is creating fewer new jobs than it used to. In the 1980s, each 1% increase in GDP led to a 0.3% rise in employment. Over the past decade, 1% GDP growth has yielded, on average, only a 0.1% gain in jobs. Growth has become less job-intensive, so the economy needs to grow faster to hold down unemployment.

One reason for this is that the government has favoured capital-intensive industries, such as steel and machinery, rather than services which create more jobs… China needs to shift the mix of its growth from industry, investment and exports to services and consumption. To adjust the structure of production requires a further strengthening of the yuan, raising the price of energy, scrapping distortions in the tax system which favour manufacturing, and removing various shackles on the services sector.

More labour-intensive growth would also boost incomes and consumption and so help to reduce China’s embarrassingly large trade surplus.
But most important, by allowing more workers to enjoy the rewards of rapid growth, it could help to prevent future social unrest.

Discussion Questions:

  1. How does China’s current account surplus result in fewer new jobs than a growth strategy based on domestic consumption would?
  2. Why would a stronger RMB contribute to greater domestic job creation?
  3. “More labour-intensive growth would boost incomes and consumption and so help to reduce China’s embarrassingly large trade surplus” Discuss this statement.
  4. Philosophically speaking, why is there more pressure on the Chinese Communist Party to maintain high growth and low unemployment than there might be on a democratically elected party such as the Republicans in the United States?

63 responses so far

Mar 31 2008

Politics, priorities, and the Phillips Curve / Asia-Pacific / China – Weak dollar troubles Beijing

Inflation, with its erosive effects on wealth and income, has plagued China at increasing rates since mid-2007. In February it reached an annualized rate of 8.7%, threatening to undermine China’s GDP growth rate, which has been predicted in the 8% range for this year.

As we have discussed in our our AP Econ class here in Shanghai, China’s inflation is caused by a combination of demand and supply-side factors. On the demand-side, a growing middle class has driven consumer spending to record levels recently, surpassing investment as the largest component of China’s GDP in 2007. Of course, as always, high inflation (thus low real interest rates), optimism about rising consumption in the future, and a comparative advantage in labor-intensive manufacturing (albeit a diminishing one as wages continue to rise) all combine to keep investment extremely high. Furthermore, cheap exports have helped keep demand for China’s output from abroad strong. The combination of increasing consumption, strong investment, and its trade surplus have resulted in demand-pull inflation.

On the supply-side, China has encountered additional inflationary pressures of late. Rising energy prices (mostly due to coal and oil shortages) combined with record rises in food prices (24% increase in the last year), have driven costs to firms up, shifting the aggregate supply curve leftward, further fueling inflation.

Knowing the damaging effects inflation has on income and wealth, it might be assumed that Beijing would place the utmost emphasis on taming the country’s rising prices. This, however,is not at the top of the government’s macroeconomic goals, according to premier Wen Jiabao:

On the issue of whether he would sacrifice economic output to bring down inflation, at the risk of increasing unemployment, Mr Wen indicated that growth re­mained the overarching priority. “We must ensure that our economy will grow…in order to ensure employment,” he said. “China is a developing country with 1.3bn people. We have to maintain a certain degree of fast economic growth to provide enough jobs.

”He said China needed to add about 10m jobs a year for the next five years, a lower figure than in the past whenPC the aim was growth of 15m-20m jobs a year.

The tradeoff between inflation and unemployment to which Mr. Wen refers is a text book example of the challenges faced by macroeconomic policymakers everywhere. This trade-off is illustrated in the Phillips Curve model, which shows that in the short-run, there exists an inverse relationship between the price level and the unemployment rate.

In his words above, Mr. Wen demonstrates Beijing’s preference in the trade-off between inflation and unemployment: He’ll take inflation… Here’s why.

In case you haven’t heard, China is not a democracy. Nor is it a, ehem, “free” country. According to Alan Greenspan in his book “The Age of Turbulence”, democracy and freedom of speech act as “safety valves” in Western countries; in other words, in times of economic or political unrest, the right to gather in the streets, the right to vent frustrations through a free press and the opportunity to advocate political and economic change through the various media, all combine to prevent violent and revolutionary uprisings when times get tough economically.

Take the US for example. Times are certainly tough right now. Inflation’s approaching 4-5%, while nominal growth has nearly stagnated. Unemployment, while it has technically fallen recently, in reality has risen as hundreds of thousands of workers have given up searching for work. The bursting of the housing bubble represents one of the most massive losses of wealth in recent history. A weak dollar has meant that even cheap imports don’t seem so cheap anymore. Throw in the desperate war in Iraq, the nuclear threat from Iran, rising food prices, $110 oil and an incredibly unpopular national leader, and by some measures the country would appear ripe for revolution. However, a revolution is about the least likely thing to occur in America, because it enjoys the “safety valve” of democracy. Rather than overthrowing their government, Americans have the right to go to the pole and vote for a new one, which in all likelihood will occur this November when it seems either Barrack or Hillary stand the greatest chance and winning the White House.

Now let’s look at China. The picture’s not quite so gloomy for the Chinese right now. Yes, inflation is high, as in the US. But unlike America, China is still growing at a very healthy pace, unemployment is probably still below its natural level, the real estate markets in China’s cities are still booming, meaning the middle class residents there are experiencing leaps and bounds in terms of personal wealth. Demand for its exports remains strong, and ever more poor Chinese are finding jobs in high paying factories across the country. Investments in capital, infrastructure and education point towards a bright future of continued growth for the foreseeable future.

But wait, 8.4% is something to worry about, especially when we take into account the 24% increase in food prices. Shouldn’t Wen and Beijing be taking drastic steps to reign in this high rate of inflation? In short, NO, they shouldn’t. Because as can be seen in the Phillips Curve, to reduce inflation could result in another, far more serious problem for Beijing; rising unemployment.

It appears that Beijing’s greatest fear is a population out of work. Its goal of creating 10 million new jobs is ambitious, but in the eye’s of the government, necessary. The Chinese people do not enjoy the “safety valve” of democracy through which economic frustrations and hardships can be channeled were the country to experience a slowdown in growth and an increase in unemployment. The last time the economy faced high inflation AND high unemployment, students, workers, soldiers and tanks all gathered for an afternoon of urban warfare under Mao’s somber gaze in Beijing. To avoid such massive revolutionary movements in the future, Beijing must do all it can to insure job creation continues and growth remains strong, even if the trade-off is record high inflation.

This one passage spoken by Wen Jiabao, China’s premier, tells a vivid story about the reality of Communist dictatorship in China. Sound economic policy may go on the back burner in times of political uncertainty. Price controls, such as those on petrol in Shanghai (speaking of, the long lines at gas stations are back!), were a microeconomic example of bad economics; Beijings hesitance to seriously tackle inflation is a macroeconomic example. Holding on to power seems to be more important than stabilizing prices, at least for now.

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Nov 13 2007

“What’s sinking the dollar?” – for IB students

What’s sinking the dollar? – November 26, 2007

The US dollar has continued its downward spiral against the currencies of many of its trading partners. Today an American wanting to exchange his or her dollar for a Euro would have to fork over $1.46; for a British Pound, $2.07, and for a Canadian dollar, $1.05! It’s been 35 years since the Canadian dollar was even near parity ($1US = $1CA)! But what are the real forces behind this continually sinking dollar? This article lays it out straight and clear:

The forces behind the dollar’s weakening have been building for years but didn’t have much effect until recently. Most fundamentally, we Americans have been living beyond our means, buying more from the rest of the world than the world buys from us (that’s the trade deficit); to do that, we have to give foreigners claims on our assets in the form of government bonds and corporate bonds, or sometimes the assets themselves. A country as rich as America can do that for a long time, but eventually the world ends up holding more dollars than there is dollar-denominated stuff they want to buy, so they start offloading dollars. They also worry that any country with loads of debt–even the U.S.–may be tempted to inflate its currency, and that fear reduces its value.

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