Look out for the 'J curve'

Economic theory tells us that when a countries currency depreciates (falls in value) that export prices fall, import prices rise and that following the law of demand the level of net exports, X - M, (the balance of trade or current account) will grow.

It's not quite as simple as that. Firstly it takes time for the change in export and import volumes to occur. At first they will stay the same. This means at first export values stay the same (valued in the country's currency) and import values rise (values in the country's currency). So the balance of trade, or current account or net exports at first gets worse.

Providing the Marshall-Lerner conditions hold over time exports grow as foreigners realize they are now cheaper and imports fall as domestic customers switch to home produced alternatives. Therefore the reaction of net exports should be to initially worsen, then improve, and when plotted against time this looks like a 'J'.

 

Following the Brexit vote the value of the British pound fell, up to 20%. Therefore we might expect to see a J-curve effect on the British trade balance.

The data does not yet show this clearly. One reason is that the effect from t1 in the diagram above to the point where the current account turns into a surplus is thought to be about a year and a half. As we are six months in to the process we should only have seen a worsening of the trade balance so far.

 

UK Balance of trade December 2015 to November 2016 (latest data available in Jan 17)

The data shows the initial worsening we would expect in the balance of trade after the late June vote and fall in the pounds value. This isn't a smooth J-curve though.

The reason that we don't see a textbook J-curve is because all variables don't stay the same. In 1967 the UK devalued the pound in a fixed exchange rate system from 1:US$2.8 to 1:US$2.4. And that rate remained fixed until 1971. Therefore there was certainty and stability in the exchange rate after 1967. That isn't true of the current situation, where the pound continues to fluctuate in value in a free floating exchange rate system.

 

UK Pound value against US$ Jan 2016 to Jan 2017

As is clear from the path taken by the UK pound against the US$ there remain variations in value. This is partly because of changing business and consumer confidence as more news arises over the likely results of Brexit.

Therefore we should be looking for evidence of a J-curve effect, but remember we don't live in a world where one change is followed by stability of all variables that allow us to see the elegant relationship the textbooks tell us about. But it should be there, just partially obscured.

The Independent covers the latest trade figures here

This topic is of specific interest to IB students for their international economics section of the course. However the effect of the changing value of a currency is equally important to VCE students as the fall in the exchange rate of the A$ since 2012 and especially since 2014 is highly significant.

Egypt floats it's currency to gain advantage

Egypt has announced that its currency will move from a fixed to a floating exchange rate from Sunday. In anticipation of a decline in the value of the Egyptian Pound it has been devalued in the fixed rate system by 48% (almost certainly to prevent speculative gains).

This is a pretty rare event and hardly ever seen in the opposite direction (floating to fixed), so its probably a permanent move, which is important for our analysis.

The Egyptians hope that the depreciation/devaluation (both are going to occur floating/fixed regimes) will boost their economy. The competitiveness of Egypt as a tourist destination will be greatly improved, and this is their most important industry. Whether this will be enough to persuade tourists to return is another issue as the country has been very unstable recently.

Notice in the article the Egyptians acknowledge that it will take eighteen months 'to see changes' and this is possibly a reference to the 'J-Curve' effect.

Notice how maintaining the fixed exchange rate has caused significant problems for Egypt recently and the examples of how they have tried to maintain the chosen fixed rate.

There is a massive downside to this move. Imported goods will cost more and this is going to impact on the poorest households the most as imported food and fuel rise in price. There will be a significant impact on the distribution of income.

Will this move actually work? Well that will depend in part on the Marshall-Lerner conditions being met. If they are then Egypt will see an improving current account balance and a reduction in the rate they are accumulating foreign debt. However the problem of tourism isn't one of price (or Price Elasticity of Demand), rather the demand curve for Egyptian holidays by foreigners shifted violently to the left due to the political instability the country has experienced.

In the long term, and this must be seen as an irreversible move, the potential gains may only be fleeting. Egypt will gain competitiveness initially, however their high inflation will continue to erode that. Further they will now have to cope with the unpredictability of a floating exchange rate and it might be expected that the Egyptian Pound will be quite unstable in the longer term bringing a large dollop of uncertainty to the already hard pressed businesses of Egypt.

Note that floating the exchange rate is one condition of IMF help to the country. This is another issue, but space dictates it can't be dealt with here.

The NYTimes covers the story here

This story is really for IB students. It has relevance to both International Trade and Development economics and is an excellent modern example of the debate between fixed and floating exchange rates.

UK trade deficit

The UK has just recorded a record trade deficit on the Current Account. At 7% of GDP for the last quarter it is quite a large one.

The BBC article linked below describes what a trade deficit is and why running one might be a bad thing and when it can be coped with. Overall an excellent educational article on a current event.

I want to talk about why the trade deficit has widened and what it's implications are.

The UK economy grew in the last year. By 2.5% according to the latest data. That is actually quite high compared to the rest of the EU and other developed countries. As imports are a function of income economic growth means higher imports. (M = mY where M = total value of imports, m is the fraction of income spent on imports, known as the marginal propensity to import, and Y is Real GDP or national income.) So if a country grows faster than its trading partners it can expect its imports to grow faster than its exports.

The UK has recently seen a fall in the value of the Pound (a depreciation). This will make exports cheaper and imports more expensive so an improvement in the current account balance will follow if the Marshall-Lerner conditions are met. The chart below shows the UK pound against the US$.

 

The recent fall in the pound is seen clearly in the graph. So why has the UK current account not improved? The Marshall-Lerner conditions certainly apply to the UK. The answer lies in the J-Curve effect, the current account worsens before it improves because the UK Pound value of imports rise while the Pound value of exports remains the same after the depreciation.

We should also consider the impact on UK Aggregate Demand (AD). (X - M) is a component of AD and so this worsening current account will act as a drag on UK growth, at least until the J-Curve effect works through to an improvement in the Current Account deficit.

The BBC article is here

VCE students will find the article an excellent explanation of the significance of foreign debt. IB students will also understand the process of the depreciation of a currency and the application of both the Marshal Lerner conditions and J-Curve effect. All students should consider the impact of a larger Current Account deficit on the wider economy through AD/AS analysis.

Growth in Australian economy 'not that bad'

Everyone knows that the mining boom is over. The non-mining sector is doing its best to save the economy from recession, but who actually gave it much hope?

Recent figures show that the Australian economy is growing much faster than we thought and 3% for 2015 isn't unreasonable. Of course this is at the lower end of Australia's growth target, but given the collapse of commodity prices and the decline in mining investment it is a nice surprise.

The Guardian have provided another excellent survey of economic data in the article linked below.

Notice that net exports are now a significant contributor to Australian growth. This is not from mining, but the non-mining sector. The depreciation of the Australian dollar has helped competitiveness and we are now seeing the 'J-curve' effect and confirmation that the Marshall-Lerner conditions apply.

Of course consumer spending (the largest contributor to GDP) and housing continue to be important. Should consumer sentiment drop there is still a danger of recession.

A good look through the data is advisable to all students, and you can play with the interactive graphs.

The Guardian article is here

This article is essential reading for VCE Economics students. Understanding the influences on the Australian economy over the last four years (demand and supply side) is critical. For IB this article shows how a depreciation in the exchange rate has worked through to higher net exports as well as providing important examples for both Paper 1 and 2.