IB Econ Study Guide Internationals - Sunny Hills High School

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114 Purchasing power parity . Some economists use the concept of purchasing power Overall, empiricai support for purchasing power parity ls parity to help predict long-run movements in the foreign mixed. PPP often fails. Why? Several reasons complicate exchange value of a currency. issues: . Purchasing power parity (PPP) is a measure of the equilibrium value of a currency - the exchange rate toward which the currency will move over time. The PPP rate is that rate that will equate the cost of purchasing the same basket of goods in two countries. lf a currencyb market exchange rate is presently below its PPP value, PPP advocates will argue that the currency ls undervalued and will therefore aooreciate in the future. For example, consider the basket of goods and services purchased by the typical consumer in both countries. Assume that it can be bought in Europe (EU15) with The basket of goods and services consumed by the typical consumer in each country may differ substantially. The basket of goods and services bought by the typical consumer also includes non-traded goods. lf, given the market exchange rate, real estate is cheaper in the'other' country we cannot import buildings and housing from it. Trade barriers and transport costs do exist so many goods and services cannot be imported freely. Most importantly, exchange rates are highly influenced by capital flows and thus by interest rate differentials and rh:nno< rn avno.trii^n< €100.00 whereas one needs $ 160.00 to buy it in the US and that the market exchange rate is €1 .00 = $1.47; then PPP is, howevet extremely useful as a conversion factor Purchasing power parities should be used instead of one may argue that the dollar is overvalued and will tend to depreciate (or equivalently that the euro is undervalued and willtend to appreciate). An American could go to the foreign exchange market and purchase €100.00 with only $147.00 and buy the same basket of goods and services market exchange rates as conversion factors (to a single currency, usually the US$) of cDP and per capita GDP figures, in order to incorporate cost-of-livrng differences that will make cross-country comparisons of these variables more meaningful. in Europe for which she would need $ 160.00 to buy in the US. The theory thus suggests that in such a case US imports of goods and services will rise. But, as more Care should be taken for the PPP value to accurately reflect cost-of-living differences. In December 2007 China's economy (its GDP)'shrunk' considerably as the dollars will be offered in the foreign exchange market to buy the necessary euros, the dollar will be pushed down (the euro up) until the dollar falls (the euro r ses) to €1 .00 = $1.60. Purchasing power parity theory may be helpful to forecast the long-run value of a currency but its usefulness to predict short-run variat ons is very strongly doubted. Not only will it take a long tlme for the equilibrium value as defined to be reached but, in addition, there are many other economic forces that may keep the value away from equilibrium. price data used for China were from 1980 and did not reflect current living costs. Living costs in China had increased over the period substantially so using the new more correct data decreased the size of Chinas economy lly almost 40%. The balance of payments What is the balance of The balance of payments is defined as a record of all transactions of a country with the rest of the worid over a period of time, usually a year. Transactions which lead to an inflow of currency enter the account with a plus sign and are known as credit items whereas those that lead to an outflow of currency enter with a minus sign and are called debit items. The balance of payments is divided into two major components, the current account and the capital account. The sum of these by construction is equal to zero. The balance of oavments baiances.
Current account The current account includes visibles and invisibles. Visible trade refers to exports and imports of goods (their difference constituting the lrade balance). Invisibles include net trade in services such as financial, consulting, shipping, aviation, tourism, insurance, net income from investments (PlDs = profits flowing in and out of a country, interest receipts and payments and Capital account dividends) and, lastly, net transfers (including private transfers such as remittances of foreign workers back home and government transfers such as expenses for embassy maintenance and grant aid). . The sum of visibles and invisibles is the current account balance. lf it is negative there is a current account deficit whereas if it is positive it is referred to as a current account surplus. The capital account (also referred to as the financial for more currency to flow out of a country than had account since the 1990s) lncludes changes in shorl-term flowed in unless somehow this deficit was financed: and long-term external assets and liabilities of a country either by drawing on foreign exchange reserves and/or It records the buying and selling of stocks and bonds, deposits, lending and borrowing as well as FDI (foreign by offlcial borrowing. lf we add the financing of a deficit (the decrease in foreign exchange reserves and/or official direct investment). borrowing) then the account will balance. conversely, if When a resident of a country buys foreign bonds or more currency had flowed into than out of a country then stocks, or if she buys a foreign business, this is a debit there would be a balance of payments surplus. The official item as currency flows out of the country and is recorded reserves would have to increase and/or lending would with a minus sign, and vice versa. The capital account can thus be in deficit (if we acquire take place for the overall balance of payments to balance. . lf, despite the inclusion of the official financing item, the more foreign assets than foreigners acquired domestic account does not balance then this is the result of errors assets) or in a surplus. and/or omissions. The balancing item ensures that the The capital account though also includes officialfinancing (or changes in official reserves) and the inclusion of this item is what forces the balance of payments to balance. It would be impossible over a period of time (say, a year) sum total is zero. lf the balancing item is large then this is an indication of poor data collection and statistical services and/or of illegal (drug/arms) sales or purchases. Correcting imbalances Remember a current account deficit exists if the sum of net exports of goods and services plus net income from investments plus net transfers is negative (it is acceptable, even though not strictly speaking correct, to say that it exists when the value of imports of goods and services exceeds the value of exports of goods and services). Whether a current account deficit is or is not a problem first of all depends on its size. To determine the importance of a current account balance we always express it as a proportion of GDP so that the size of the economy is'scaled out'. ltaly's current accouni deficit in December 2007 was 47.7 billion dollars whereas Greeces was less at 43.2 biliion dollars. Only when expressed as a orooorlion of GDP does one realize that it is Greece that has the problem as its current account deficit is 13.6% of its GDP whereas ltaly's is only 2.5% of its GDP (Dec 2oo7, The <strong>Econ</strong>omist). Typically a current account deficit is considered serious enough to examine if it is widening and exceeds 5%-6% of the countryS GDP Whether a current account deficit is a problem also deoends on the reasons for which it exists. More specifically it depends on whether it is temporary or persistent (also referred to as fundamental). Temporary deficits are short term being either of a transilory nature (e.9. because of a crop failure) or of a reversible nature (e.9. as a result of a booming economy). In the latter case a shoTt-term current account deficit implies an improvement in living standards as the nation is consuming more than it is producing. A strong and growing economy typically records trade deficits as a result of the increased import absorption (assuming of course that groMh was not export-led in the first place as in the case of, say, China). Also, a developing economy in the process of establishing certain industries may initially be forced to rely on imported capital goods, leading to trade deficits. Fundamental imbalances are chronic. They tend to last for a lono time and thev are the result of structural 115
Page 1 and 2: International economics Free trade
Page 3 and 4: 100 Does it make sense? Economic ar
Page 5 and 6: Voluntary Voluntary export restrain
Page 7 and 8: The bilateral/regional . The region
Page 9 and 10: The terms strictly refer to offlc,a
Page 11 and 12: Exchange rate This has two effeds:
Page 13 and 14: Why do Factors that may affect inve
Page 15: How does a fixed It will be maintai
Page 19 and 20: Current account Remember a current
Page 21 and 22: Terms of trade: causes and effects

IB Econ Study Guide Internationals - Sunny Hills High School

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