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Exchange Rates Currency Manipulation Eduqas Question

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Date : 09/10/2018

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Charles

Uploaded by : Charles
Uploaded on : 09/10/2018
Subject : Economics

The US has recently accused a number of countries of keeping their exchange rates below their free market level. The US has chosen three criteria to use in order to help identify countries which may be using unfair currency manipulation against the US. These criteria are that the country has:

(1) a trade surplus of larger than $20 billion.

(2) a trade surplus with the U.S. that is more than 3 percent of that country s own GDP.

(3) engaged in Persistent one-sided intervention in currency markets, defined as purchases of foreign currency amounting to more than 2 percent of the country s GDP in a one-year period.

Five countries (China, Japan, Korea, Taiwan and Germany) currently meet two out of three of these criteria.

Evaluate how likely it is that a country meeting any two out of the three criteria above is manipulating its currency unfairly. (20)

An exchange rate is the price of one currency in terms of another. In a free market the price of any currency is set by the interaction of supply and demand. Some in the Trump administration argue that it is currency manipulation, that is consistently buying dollars, which puts upward pressure on the dollar making foreign goods cheap to buy leaving America with enormous trade deficits and jobs being exported from America.

A large trade surplus, for example $20 billion, should put upward pressure on a country s exchange rate. For example, if Japan has a large trade surplus with the US then this means that dollars are being sold to buy yen with which to pay Japanese companies. However, trade is just one of the factors that drives changes in exchange rates. Currency traders often see the dollar as a safe haven during turbulent times and sell a variety of currencies to buy dollars, thus pushing up the price of the dollar relative to other currencies. The scale of these currency flows is so enormous, that they are very difficult for any country, even with big foreign currency reserves, to manipulate downwards.

Foreign exchange rates are not just set by changes in visible and invisible trade, but also buy movements on the Balance of Payments capital account. People and institutions in the named countries may wish to buy assets in the United States such as property, shares and Treasury Bills. In so doing, they will sell their own currencies and buy dollars and other things being equal push the demand curve for dollars outwards and thus pushing the dollar exchange rate upwards. By running large fiscal deficits which need to be financed it is very easy for the above countries to buy T Bills and put downward pressure on their own currency vis a vis the US $. If the US regards this as currency manipulation, then it could stop it by the US Federal Government raising enough tax to pay for its spending. This would probably reduce private consumption and therefore reduce the trade deficit.

It is likely that foreign governments are aware that by buying US assets such as Treasury Bills they are putting upward pressure on the US dollar and as a result making it easier for their exporters to sell goods to US consumers. The huge budget deficits and the dynamism of the US economy which makes buying shares in many US companies attractive, means that people and institutions in the named countries have every reason to buy dollars in order to buy those assets. Hence, it very easy for the named countries to spend huge sums, going towards 2 per cent of GDP, buying dollars on the foreign exchange markets: the federal budget deficit gives them a good reason to do it. However, it is within the power of the US government to raise taxation, and other things being equal, the deficit, which reduces opportunities for foreign investors to buy T Bills and therefore the need to buy dollars (the demand for dollars is derived), or raise interest rates to discourage US private consumption and thus reduce the trade surpluses of those countries with the US. It is likely that the trade surpluses are a result of the named countries being net savers while the US is consumer of the last resort

The trade surpluses of the named countries may simply reflect comparative advantage and the production strategies of trans-national corporations. Apple chooses to use contractors in China to make its products because of the low unit labour costs there. It would take a very sharp rise in the value of the Chinese currency (Yuan) to cancel out the competitive advantage that China has in this type of manufacturing.

In conclusion, it is likely that the named countries may go in for some currency manipulation, but the large size of the US federal budget deficit invites the named countries to do that. The big trade surpluses do not necessarily point to currency manipulation but to big imbalances in saving and consumption between the US and some of its trading partners such as China. If the US put its own fiscal house in order and did not borrow so much this would make it much more difficult to manipulate its currency. Does the US want foreigners to stop lending it money, so it is forced to hike interest rates, so Americans save more?

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