Sunday, November 23, 2008

Economics SL: November 2005; SP2; Q5: on the dollar and the euro

This was a question on a recent quiz we had. The best part of the question is the advice given by Lehman Brothers....

Anyway, here are some tips on this question:
a(i): exchange rate: the price os a currency expressed in terms of another currency (or, the number of units of a foreign currency required to buy a unit of the domestic currency)

a(ii): depreciation: refers to a decrease in the price of a currency withing a flexible (free floating) exchange rate system (eg from $1.00 = euro 0.80 to $1.00 = euro 0.70 --> the USD depreciated, it's now cheaper to buy; rem that a vague definition with an example or a diagram may push you to full points)

b. You are asked to 'explain (using a diagram) one reason for the fall in the value of the US dollar'. Remember that you earn two points for a (correct) diagram and 2 points for a (correct) explanation. Since the points awarded for the explanation are only 2 you need not spend too much time on it. The diagram here could have on the vertical axis 'Price of USD expressed in euros: euros/$' and on the horizontal 'USD traded per period'. You need a demand for USD (which expresses the value of exports of the US as well as capital inflows into the US) and a supply of USD (which reflects the value of US imports as well as outflows of capital from the US). Since the question asks for 'one reason' you need not refer to the text even though it would be better (but not necessarily more rational on your part on a test). Reasons you could quote that relate to the text include the rise in UK interest rates (paragraph 4), the low US interest rates (paragraph 3), the widening US current account deficit (paragraph 2) or the lack of confidence of foreign investors in the future performance of the US economy (paragraph 2).

For example, since US interest rates are low (and now relatively even lower to the UK interest rates which increased), there willbe an outflow of capital from the US. Investors will sell US assets like US bonds and US dollar deposits as they are not attractive (low - lower rate of return). Supply of US dollars in the forex markets will rise (shift to the right in you diagram) pushing the dollar down.

Or, since a widening current account deficit means that US import spending rises (faster than export revenues do) it follows that the supply of dollars is increasing (shifting to the right; faster than the demand is), pushing down the USD.

Or, since foreign investors do not feel confident about the performance of the US economy demand for USD will fall (pushing down the USD) as demand for US shares will weaken (and for FDI into the US).

Any of these would do and given the wording of the question there was no need to 'connect' to the extract.

c. You are asked in this one to explain (using an AD/AS diagram) why Japan 'fears a high-valued yen'. The key is to realize that the higher the value of a currency the more expensive and thus less competitive abroad are the country's exports. If a Toyota is priced at Yen 100 and the dollar-Yen exchange rate changes from Y100 = USD1.00 to Y100 = USD2.00 then an American who needed 1 dollar to buy the car would now need 2 dollars. The dollar price of the Japanese export increased. The second useful point to keep in mind is that AD (total spending on domestic goods and services per period) is equal to the sum of (C+I+G+X-M). Obviously, spending on domestic goods and services by foreigners is included (X). It follows that the high Yen implies pricier and thus less competitive Japanese exports and thus a decrease in X and thus Japan's AD. Drawing an AD/AS diagram for the Japanese economy with the average Japanese price level (P) on the vertical and Japanese real output/ income (Yr) on the horizontal you would need to shift left from say AD1 to AD2 the AD curve which would be responsible for a lower equilibrium level of (Japanese) real output/ income. It makes a lot of sense for Japan to fear a 'high-valued' Yen: it could lead to slower growth (or, recession) and higher unemployment.

d. This one asks you to evaluate "two methods that the US government might use to correct its 'exploding current account deficit'". Well, if you are asked to evaluate two methods, you should first come up with two methods and explain how each would in principle work to do the job! You are not asked to present these metods in broad terms but given that the syllabus does indeed present them with their 'names' (see section 4.7) you could organize your answer around the ideas of expenditure changing (reducing in this deficit case) and expenditure switching policies.

Expenditure changing policies refer to demand side policies that would affect AD and thus Y, banking on the fact that import spending (M) is positively related to the level of national income (Y). So, if you need to lower M (to treat a widening current account deficit) you might as well try to lower Y by applying the brakes on fiscal policy. But lowering Y implies slower growth (or, even inducing a recession) so the opportunity cost of such a policy could be a rise in (cyclical) unemployment. Economic activity will slow down, some firms will go under others will suffer lower sales and workers will be laid off. The short term cost may be significant (but necessary). As any inflation would also be contained, exports may benefit as well as import competing firms (so X rises and M falls - what we're after).

Expenditure switching policies (the second major choice) refer to policies that aim at switching expenditures away from imports (so, M decreases) towards domestic goods and services. The trick is to make imports pricier and thus less attractive! What about protectionism (tariffs, quotas etc) or a devaluation (rapid depreciation)? Tariffs (and quotas) increase the domestic price of foreign goods, so, voila! The problem is that the 'other side' (i.e. the country's trading partners) will probably get pretty upset. Also, within the WTO (and any RTBs), tariffs etc are not easy to get by with. Increased protectionism is bound to create trade frictions, especially if we're talking about a huge economy (an engine, or ex-engine, of world growth) as the US. Think of the current discussions on whether president-elect Obama will or will not pursue protectionist policies. Frictions and the possibility of retaliation diminish the attractiveness of such a policy choice.

What about a devaluation / depreciation of the currency? Well, exports get cheaper (more competitive) and imports pricier (and, less attractive). This may do the trick as X will tend to be boosted (thanks M.M. for the expression - I know you like it!) and imports will tend to decrease. But, there is a risk of inflationary pressures arising. If such a scenario remains unchecked then any benefits from the devaluation could be short lived.

Interestingly enough, the extract is not very helpful to use in this evaluation! One could note that in paragraph 4 it states that 'most of the burden of the dollar’s depreciation has fallen on the euro as the major Asian economies have defended their currencies against any appreciation. China’s renminbi is pegged to the dollar and the Chinese administration has rejected suggestions from the White House that the Chinese allow the currency to rise' This suggests that the US should insist that the Chinese revalue the yuan (the remnimbi) against the USD so that Chinese goods lose some of their attractiveness inside the US and so that US exports become more competitive in China. Given the huge bilateral US trade deficit with China this could help the most.

Also, the info in paragraph 2 that 'the US will not be able to attract enough investment' suggests that the US current account deficit is not temporary (and thus reversible) but of a rather fundamental (structural) nature. The US seems like a 'sick' economy (well, we are witnessing the outcome of these structural problems in a terrible way now - 5 years after this article was written). If private investors seem unwilling to buy US assets then their outlook for the future economy is obviously poor. What is the 'sickness'? Perhaps that 'too much spending' (public and private) was allowed for too long. Huge budget deficits and a massive spending spree by the private sector may be at the bottom of all this.

In any case, try to at least use quotes that refer to what is happenning to the USD, to the size of the current account deficit etc so that your answer is not in a 'vat' something which would prevent you from being awarded level 3 points

*** for higher level candidates only: remember you could use here the idea of the 'twin'deficits: Given that, in equilibrium, withrawals (W) must equal injections (J), or that (M + S + T) must equal (X + I + G), if there is a budget deficit (so that G > T) and assuming that the private sector is in equilibrium (so that S = I) then M will necessarily exceed X. Imagine if the private sector is also in deficit (perhaps because of ultra low interest rates - something for which now, Alan Greenspan is accused...!) then the current account deficit is even bigger. If G decreases and T rises (contractionary fiscal; an expenditure reducing policy ) then, the current account deficit will narrow (more so, as private spending will also shrink)

BTW, I owe a public thank you to Katerina D. for the email she sent me! What a girl!

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