Exchange Rate Appreciation and Inflation....

" China is reported to be accelerating the appreciation of the yuan to combat inflaton instead of increasing its interest rates, in part because of expectations of further cuts in US interest rates. How does appreciation combat inflation?" - Jane

That's an excellent question! There are a number of avenues available for the central bank to try to combat inflation. They've already tried price controls, that I've argued elsewhere will ultimately fail. They've also raised interest rates a number of times as well, an avenue that is more likely to be successful. But perhaps the most effective way to combat China's inflation rate is to allow the currency to appreciate more quickly.

How would that work? Well, as I wrote here, inflation ultimately results from demand exceeding supply within the Chinese economy. An increase in the value of the currency makes Chinese goods relatively more expensive and foreign-made goods relatively cheap. Thus demand for Chinese goods will fall, reducing demand and therefore inflation pressure in China.

There's a related effect as well. China is accumulating foreign reserves at a rapid rate, which means that it is buying foreign currency with domestic currency. To do this, it is expanding the domestic money supply. As Milton Friedman famously said, "Inflation is Always and Everywhere a Monetary Phenonemon." Increase the price of RMB and the demand for RMB will fall- reducing the need for Mainland authorities to increase the money supply.

China.... consume or save?

"We're told that saving rather than consumption will ultimately lead to increased economic growth, as saving will encourage increased investment. However, some commentators insist that Mainland China take steps to increase domestic demand, which is the exact opposite. Why is that?" - Zheng

That's an excellent question! The issue with Mainland China is that it has developed very rapidly on the basis of ever increasing exports to the rest of the world. At the same time, the high level of domestic savings has financed increasing levels of foreign investment outside of China.

But this may be a fragile source of growth. There is growing resentment in some of the rest of the world as China's low-cost production drives foreign domestic producers out of business (irrational, in my view, since the rest of the world benefits on net from free trade with China), leading to increased talk of protectionism. (A by-product of China's massive trade surplus is its growing foreign currency reserves).

Also this makes China's continued development very dependent on the economic health of the rest of the world. Right now, with the US on the brink of recession, it is easy to see that this may not be in China's best interests.

Finally, and most importantly, China appears to be suffering from a serious imbalance. Why does the Chinese economy as a whole save up to 40% of total income (see here)- much higher than nearly any other economy? This suggests some structural problems that the Mainland Government would do well to try to rectify.

In sum, many commentators interpret China's high savings rate and massive trade surplus as symptoms that something is not right in the Mainland economy. It's the "something" that they'd like to see change, rather than the savings rate per se.

The Great Moderation

Here's an excellent discussion on the Freakonomics blog on "The Great Moderation," and why the probability of recession in the US may be overstated.

I'm not convinced.... a large housing correction as we are now seeing in the US has always predicted a recession in the past (see this post on the Calculated Risk blog, for example). I don't think the mechanism will be any different this time around.

Yes, the evolution of the economy and improved macroeconomic policy may have resulted in an increased ability of the economy to adjust to a range of different shocks, but that doesn't mean that it can avoid recessions under all circumstances! If the shock is big enough (as the current one appears to be), we'll still get a recession.

Discouraged Workers and Unemployment...

According to the text, if discouraged workers are not counted as unemployed, the unemployment rate will be understated during recessions. Why is this? - Jane

The unemployment rate = 100* unemployment / (unemployment + employment). An increase in the number of discouraged workers decreases both the numerator and the denominator by the same amount. But because the numerator (unemployment) is much smaller than the denominator (unemployment + employment), in percent terms the numerator declines by more. Hence the measured unemployment rate falls.

Price Controls and Shortages...

One week ago, I discussed the likely consequences of the newly-introduced Mainland price controls here. I argued that "Price controls never have been, and in my view never will be, an effective policy to try to lower inflation." Previously, I've argued that price controls lead to shortages.

Well, guess what? From today's SCMP...

Worst-ever coal shortage sees stocks fall 40pc
Emergency measures taken as provinces ration electricity

The mainland has issued an emergency circular to ensure power supplies after an unexpected power shortage of nearly 70GW.
.....
In an effort to ease inflation, the State Council had announced this month that power producers would not be allowed to raise electricity prices in the short term, preventing them from passing on the rising cost of coal.
........
"It's a battle between power companies and the central government," said Great Wall Securities analyst Zhou Tao . "While coal prices are going up and an electricity price rise is ruled out by the government, the electricity companies are reluctant to buy much."

Electricity prices cannot be increased because of price controls, but the cost of generating electricity is rising due to rising coal prices. Profit maximising electricity producers respond by reducing the supply of electicity, resulting in power shortages.

The best response? Deregulate electricity prices, allowing these to move with the cost of production. The most likely response? Regulate coal prices, to reduce the cost of electricity generation. But this would not work: it'll merely result in shortages of both electricity AND coal, as profit maximizing coal producers respond to decreasing profit margins by decreasing the supply of coal.

I repeat: PRICE CONTROLS DO NOT WORK.

Negative Real Interest Rates...

From today's SCMP:

"HK slips into negative interest rates. With local lenders responding to Fed cut, prime drops below inflation level of 3.8pc.
....
The result is a negative interest-rate scenario, reminiscent of the mortgage rate from 1991 to 1994. At 4 percentage points below prime, the mortgage rate now stands at between 3.1 per cent and 3.25 per cent, below the inflation rate measured at 3.8 per cent last month."

Effectively, if you have a mortgage, the Bank is now paying you, rather than the other way around! That is, you will pay back your loan in future, inclusive of interest, with less real money than the loan is worth today. And the likely result?

"Property agents said negative mortgage interest rates would help bring the market back to 1997's peak levels faster....."

Does that mean you should buy property? Not necessarily. First there are the transaction costs, that amount to about 5% of the value of the property, and then there is the risk of future property price movements. IF the US recession spreads to Asia, expect property prices to decline significantly, which would wipe out any gain from negative real interest rates many times over.

Zimbabwe Inflation, again....

On the continuing saga of Zimbabwe hyper-inflation, there is now a $10m banknote, which is about enough to buy one drink in a bar- see more at the Undercover Economist here. For my previous take on the causes and consequences of Zimbabwe inflation, click here.

Hong Kong Inflation

Inflation in the CPI is up to 3.8% in Hong Kong, according to the Census and Statistics Department. That is, the average price that consumers paid for consumer goods in December 2007 was 3.8% higher than than in December 2006. This is the highest level of consumer inflation since June 1998, almost 10 years ago!

The driving force behind Hong Kong's inflation is rapid growth across the border in Mainland China fueling increased demand here. As long as China's rapid develop continues, coupled with an appreciating RMB, increased demand for Hong Kong produced goods and services will put positive pressure on Hong Kong prices.

But now there is another force putting upward pressure on Hong Kong prices. Yesterday the US central bank cut interest rates by 75 basis points, or 0.75% (for an analysis of the rate cut, see James Hamilton's comments here). This implies that interest rates in Hong Kong will drop as well, as a result of Hong Kong's currency board system that effectively fixes the exchange rate between Hong Kong and the United States. (See earlier posts here and here to understand why).

These lower nominal interest rates imply cheaper mortgages and loans in Hong Kong, which will likely fuel further increased demand and therefore inflation in Hong Kong.

The bottom line: expect price increases in Hong Kong to accelerate further in the short run.

Reading more....

"I want to read more about economics news. What do you suggest?" -Zheng

There are many excellent resources on the web. For detailed economic discussion of the business cycle, for example (something that we will cover in class later in the year), Econbrower is excellent- although it does focus almost entirely on the US economy. For more general reading, check the Freakonomics blog or the Undercover Economist. For slightly more eclectic discussion of all things economics, see Marginal Revolution. There's also the Economist website where you can read the latest edition of this excellent publication for free. And if you have any more time to spare after all that, don't tell me, or I'll assign more homework! :-)

If you do come across relevant stories that you think other blog readers would be interested in seeing, please send me the link, and I'll post them here as well.

Measuring GDP...

1. GDP can be measured as total income in the economy. Is that before tax? If yes, are all kinds of taxes included?
2. Why are inventories included in final goods? -Guo

To answer your questions, remember that GDP is a measure of the total value of all production in the economy. When we measure this production by adding up income, we want to include all income earned in the production process, including that earned by the Government via taxes. So yes, we wish to include all taxes. Typically we do this by including income before taxes are deducted (i.e. gross income rather than net income), except for indirect taxes paid by firms which we add back to correctly calculate GDP.

Inventories are included as a way to match production correctly. Recall that Y=C+I+G+NX. If a good is produced in year1 but consumed in year 2, it is included in I (inventories, a part of investment) in year 1. When it is consumed in year 2, inventories decline by the value of the good, while consumption increases by the value of the good; these cancel out, so there is no net effect on GDP.

Of course if the good is sold for more than its value as inventory, then GDP will also increase in year 2, but only by the increased value of the good when it was sold. We can think of this as the value of the service of selling the good, which rightly belongs in year 2's GDP, not year 1's.

Real vs. Nominal

"What is the real price (for example of oil)? What is the difference between the real and nominal price? Do real prices change over time?" - Phillip

A nominal price is measured in terms of units of money- for example, oil is currently $88USD per barrel. A real price is adjusted for changes in the value of a unit of money- for example, if prices had risen by 20% since 2000, we'd say that the real price of a barrel of oil is (88 x 0.8) USD per barrel in year 2000 USD. Real prices changes over time, but generally by smaller magnitudes than nominal prices.

China vs. India

China and India share many similarities. Both are rapidly developing, relatively poor, huge economics who are together changing the shape of the world economy. But they have some fundamental differences, and their economic growth is occuring in radically different sectors. According to Marginal Revolution, that's mainly down to different labour laws. Read more here.

Compensating the losers fo Free Trade agreements...

When international trade opens up, there are inevitably winners and losers. Inefficient domestic producers can no longer compete with efficient foreign producers, and end up closing shop. A common refrain from the anti-globalisation lobby is that this alone is a sufficient reason to resist free trade.

Economists don't generally buy this story, because it inevitably results in less efficient use of resources: the ineifficient domestic producers continue their inefficient production. They may instead favour compensating the domestic producers for their financial loss.

But does that make sense? As Steve Landsburg argues (quoted by the Undercover Economist reports), we don't compensate inefficient losers in other economic spheres, so why should we when it comes to international trade? Read more here.

Chinese Price Controls...

Prices are going up in Mainland China, so the Government has enacted price controls. From today's SCMP editorial...

"The tough measures introduced yesterday to cap soaring food prices on the mainland clearly signal that Beijing is seriously concerned about inflation - and determined to combat the problem. These are the most stringent controls on the prices of basic necessities for 15 years. Their introduction shows that even as the mainland continues to move ahead with free-market reforms, the government is not afraid to use tough administrative measures when it believes they are necessary."

The tone of the editorial suggests that price controls represent a difficult, but ultimately effective, policy to combat increasing inflation. I'm far more sanguine. Price controls never have been, and in my view never will be, an effective policy to try to lower inflation- see my earlier posts here and here for more.

The Coming Recession...

According to the Economist, one accurate measure of past recessions is the number of times the news media includes the term "Recession." And guess what's happened to the number of times you can find "Recession" in print in the US lately? See this link for more.

(There's actually a formal name for counting the number of times a particular word appears in print, and using this frequency as an explanatory variable. It's called "Textual Analysis" or "Content Analysis.")

Taxes and GDP

"We can calculate GDP by summing total wages, interests, rent and profits received by householders. Should we include taxes as well?" - Mandy

Yes- we should include all sources of income that are derived from the production of goods and services, and that includes income received by the Government. Normally we capture this by summing up gross, or before tax, sources of income when we calculate GDP.