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:  . 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?”

Apr 11 2011

## “A glimmer of hope” – rising incomes in China lead to rising demand for US exports

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.

Nov 02 2007

## How do changing interest rates affect exchange rates? The example of the RMB

FT.com / Asia-Pacific / China – Pressure builds over renminbi

In IB Economics, we’re currently studying the determinants of exchange rates. One important factor in determining the demand for a particular currency is the interest rates in the country whose currency is in question relative to that of other countries.

The recent cut of the federal funds rate in the US of 25 basis points to 4.5% brought the US rates closer to China’s recently increasing interest rate of 3.32%. The upward trend of Chinese rates (up 50 basis points this year) and downward trend of American rates (down 50 basis points this year) should diminish the appeal of dollar denominated financial assets and increase the demand for those in Chinese RMB. In the currency market, we should see weakening demand for dollars and strengthening demand for RMB, as US savings and government securities are relatively less appealing due to the declining returns on those investments. With further increases in Chinese rates expected (due to high inflation), the RMB should be in greater demand, as returns on Chinese investments looks to increase as rates rise. Continue Reading »

Oct 23 2007

## The US dollar’s decline in value may cause more harm than good for the US economy

Asia Sentinel – A Falling Dollar Does Nobody Any Good

Many economists hail the decline in value of the US dollar as a boon to the American economy. It may sound counter-intuitive, but economic theory predicts that when a currency depreciates relative to other currencies, this could actually be good for the country’s economy? Why, you ask? Let’s consider an example:

In the last four months the value of a dollar in terms of euros has gone from 0.75 Euro cents to 0.69 Euro cents. For Europeans, that means that dollars are cheaper now than they were four months ago, therefore American goods are cheaper now than four months ago. Cheaper American products should mean more business for American companies as Europeans demand more of their stuff. Good for business, right? In the US, aggregate demand will shift out, unemployment should fall, and the price level should rise as more foreigners demand more American products. But what impact does the weaker dollar have on Americans? Continue Reading »

Jun 06 2007

## China makes, the world takes

Here’s a great slide show and narrative about the manufacturing industry in the industrial city of Shenzen. After viewing the slideshow, discuss some of the questions below.

Discussion Questions:

1. What does the narrator mean when he says “Shenzhen is more or less an invented city?”
2. Why does the word “scale” come to the narrator’s mind as he explores Shenzhen? What key concept from our economics class includes the world “scale”? How does the growth of Shenzhen relate to this concept?
3. What is exported from Shenzhen to the US? What is being sent back to Shenzhen from the US? What does this suggest about the Chinese/US balance of trade? Why do you think this is happening?
4. Where do Shenzhen’s factory workers come from? Why do you think young women make up such a large percentage of factories’ workforces? Are the wages paid factory workers in Shenzhen “fair” wages? Why or why not?
5. Is manufacturing in Shenzhen labor intensive or capital intensive? What’s the difference?
6. What’s the significance of the last line about how Liam Casey, whose office overlooks the headquarters of the Shenzen communist party, has never “met anybody who was in there”. What does this say about communism in China today?

Next »

• ## Order Welker’s books

for IB Economics

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