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11/21/2010: "Deflation here ... inflation there"

The Federal Reserve Board in the United States has been using monetary policy in an attempt to avoid a period of deflation. Deflation is a period of sustained price drops. When this occurs there is a transfer of wealth from borrowers to lenders, and profits fall because the value of inventory falls. With interest rates already at, or close to zero, the policy tool available to the Fed is known as quantitative easing. This involves injecting large sums of money into the economy by purchasing bonds on the open market.

At the same time that the Federal Reserve is fighting deflation, the United States is also fighting a trade war with China. The United States believes that the renminbi is undervalued which gives Chinese exporters an unfair advantage compared to American producers. China's large trade surplus means that capital is flowing into China and putting upward pressure on the yuan. To maintain an artificially low exchange rate China must buy up the incoming capital by increasing the supply of yuan. The quantity theory of money tells us that increasing the money supply in excess of the increase in real GDP causes inflation.

Inflation in China would reduce their exports and increase their imports. An article in the New York Times illustrates the effect the Chinese inflation would have on North Americans. (Click here for article 1) An increase in the yuan, or an increase in Chinese prices will increase the price of Canadian and American imports. We would expect that the price of clothes toys and smart phones would increase in North America. When prices increase consumers lose and import competing firms gain. It also causes difficulties for North American companies that import from China. Due to the existence of long-term contracts the price that importers pay is fixed several months in advance by inflation in China is causing input prices to rise. There is a real danger that Chinese firms that are locked into long-term price contracts may be forced into bankruptcy. An article in Bloomberg suggests that Chinese factories are now willing to quote prices for clothing one week in advance. A wholesale price of cotton has risen by 70% in the price of finished clothing products have risen by 30%. Such firms as Wal-Mart gap and J.C. Penney are experiencing increases in the price of their products. Inflation is doing what a revaluation of the yuan would have done. (Click here for article 2)

Inflation in China is not restricted to cotton or to clothing products. A Globe and Mail article indicates that the price of fuel, grains and sugar are also rising. (Click here for article 3) Where prices are not permitted to rise shortages occur and are evidenced by long line-ups at filling stations. McDonald's has raised the price of hamburgers drinks and other items to the higher input costs. Chinese government is considering price controls in an attempt to ward off social unrest. An article in the Telegraph also suggests that the Chinese government will impose some sort of price controls in an attempt to minimize the effects of inflation. Chinese officials also realize that a fresh round of quantitative easing in the United States may lead to even higher inflation in China. (Click here for article 4)

The announcement that China was going to take steps to stem inflation cause stock prices in Asia to fall. The usual methods for fighting inflation are increases in reserve requirements leading to a decrease in the money supply and an increase in interest rates. When interest rates rise, stock prices typically fall. This makes raising funds for investment purposes more expensive. A reduction in investment spending reduces GDP and this reduces the global demand for natural resources. Prices for oil, coal, copper, zinc and iron all declined which led to a decline in the value of the Canadian dollar. This is the topic of a Bloomberg BusinessWeek article. (Click here for article 5)

A New York Times article provides greater detail of the proposed government policies in China. (Click here for article 6) The government proposes to control prices through the use of subsidies rather than through the use of price ceilings. Price ceilings are legislated maximum prices below the equilibrium level and leads to increased shortages. Subsidies reduce the cost of production and effectively increase supply. The government also proposes to increase wages to make commodities more affordable. Another article in the Globe and Mail argues that the inflation is not being caused by the increase in food prices, but food prices are increasing as a result of the inflation. The inflation is being caused by an increase in the money supply that results from an undervalued currency. (Click here for article 7)

Relevant Learning Objectives

3.3 Explain how the inflation rate is calculated and what it misses, and describes three problems inflation creates.

3.4 Use the quantity theory of money to explain where inflation comes from.

6.3 Trace the impact of high and low exchange rates on real GDP and inflation.

7.4 Explain why monetary transmission mechanisms can be blocked, and how quantitative easing can overcome a balance sheet recession.

Questions

1. Inflation in China is higher than it is in Canada. Does the difference in inflation rates accurately measure the problems in each country? Why or why not?

2. Suppose that a country has grown by 10% in each of the last two years. In that time, the money supply has increased by 54%. Use the quantity theory of money to predict the change in prices. (Assume velocity is constant)

3. Suppose that the Bank of Canada intervened in the foreign exchange market to reduce the value of the Canadian dollar. What would you expect to happen to aggregate demand, GDP and inflation?

4. The US Federal Reserve System has recently undertaken a second round of quantitative easing. What is this policy supposed to do for the economy and, according to the news articles cited herein, what effect does it appear to have had?

Sources

1. Currency fight with China divides US business, David Barboza, New York Times, November 16, 2010, accessed November 17, 2010.

2. Gap, Wal-Mart clothing costs rise on 'terrifying' cotton prices, Bloomberg news, November 16, 2010, accessed November 17, 2010

3. China moves to cool inflation as food prices surge, Joe McDonald, November 17, 2010 accessed November 17, 2010

4. China plans 'price controls' to curb inflation, The Telegraph, November 17, 2010 accessed November 17, 2010

5. Asian stocks decline for fourth day on china inflation concern, Shani Raja, Bloomberg BusinessWeek, November 17, 2010, accessed November 17, 2010

6. Beijing's focus on food prices ignores broader inflation risk, Keith Bradsher, New York Times, November 17, 2010 accessed November 18, 2010

7. After food, China faces bigger inflation challenge, Joe McDonald, Globe and Mail, November 18, 2010 accessed November 18, 2010

Michael S. Leonard
Kwantlen Polytechnic University
Surrey, BC