Global Imbalances and Purchasing Power Parity Term Paper

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Global Imbalances in Trade and Purchasing Price Parity: Evidence From Research and Current Trends

The recent global economic collapse threw into sharp relief the degree to which the world's economies are inextricably linked and co-dependent. A failure in one major economy will automatically and almost instantly have a negative effect on the other major economies of the world, and these effects trickle down in a substantial stream to all but the most isolated nations, and some shocks are even felt here (North Korea is an excellent example). One of the features of the current global economic situation that was arguably a prime contributor to the widespread and extreme nature of the recent recession is the imbalance that exists in trade relationships. These imbalances will be identified and further explored herein.

Global Imbalances: Current Trends and Potentials

One of the trade relationships most often cited in analyses of global imbalances is that which exists between the United States and China, now the two largest economies in the world (depending on the measure and the source) and hugely dependent on each other (Li & Zhu 2005; Popov 2010; Rosser 2010). Other imbalances also exist, with some countries exporting significantly more than they import and vice-versa, and this creates many complications in the global economic structure. The U.S./China relationship, however, serves as a very clear and easily examined example due to the sizes of the two economies and the immensity of the imbalance.

The "current account" of a country is essentially a measure of what it spends vs. what it earns; the United States has been running a current account deficit both generally and with China specifically for decades, meaning China has had a current account surplus with the United States (and indeed, with the rest of the world) (Scherer 2009). This particular imbalance has been made exponentially larger by the particular circumstances of its creation: the United States spends a great deal of money purchasing cheap consumer goods from its trading partner, creating the initial imbalance and send large amounts of capital to China (Shcerer 2009). Chinese consumers, on the other hand, consumer far less and save a lot more of their money, so much of this capital has returned to the United States in the form of cheaply borrowed funds, which can then be used to make purchases, etc.….and so the cycle continues until it is no longer tenable (Edwards 2007; Scherer 2009; Rosser 2010).

The evidence outlining and defining this imbalance is difficult to miss; a simple glance at the trade figures displayed on numerous websites and in a variety of articles on the subject makes it plain to see that China takes in a great deal more money from the United States than it spends in return (Popov 2010; Rosser 2010, etc.). These imbalances have also been acknowledged by politicians and policy makers from all over the world, coming from many different backgrounds of economic theory and decision-making (Scherer 2009; Edwards 2007; Rosser 2010). What is less clear is what a single national government can do about these noted imbalances, as acting unilaterally does not work in a system that is completely interconnected (Edwards 2007; Scherer 2009). Protectionist measures such as high tariffs on imports and subsidies for locally produced goods can help the United States to some degree, but they will also have a negative impact on the economy at a very delicate time. What is really needed is cooperation and the free floating of currency, as well as large scale and slow shifts in overall consumer behavior.

Conclusion

The imbalance in current accounts between the United States and China is only the largest example of a problem that exists in many international trade relationships in the current global economy. These imbalances lead to a shifting of capital resources that is not truly beneficial to any country in the long-term, as it decreases stability and thus the security of trade relationships and overall economic productivity. Addressing these imbalances is a definite necessity if the world's largest economies hope to achieve a new era of true stability and mutual cooperation. Otherwise, they run the risk of repeating events such as the recent economic downturn and the continuing uncertainty that plagues the global economy.

PURCHASING POWER PARITY

Introduction

The global imbalances in trade that currently exist are at seeming odds with certain economic theories that suggest balances are found in such relationships as long as markets remain free. China's control of its currency could help to explain its massive trade surplus with the United States without refuting these theories, for example, but the effect of an artificially cheap currency cannot explain the full imbalance, or does it explain imbalances that exist between other countries. According to prevailing economic thought, trade imbalances are in constant state of adjustment generally working towards equality and balance -- cheap goods in one country leads to an influx of capital making purchases, which drives up the cost of goods and reduces the influx of capital until a balance is returned (similarly, expensive prices in one country would limit inflowing capital, dragging prices down and restoring a greater degree of exportation). This theory is most succinctly embodied in the concept of purchasing price parity, though the true applicability of this concept in the modern global economy is a matter of debate.

Purchasing Power Parity: Theory and Application

Purchasing power parity comes in two forms, relative and absolute. The absolute form of this concept is much simpler and serves as a useful initial example. If a good can be bought for fewer dollars (exchanged for pesos) in Mexico than in the United States, demand for that good in Mexico and the demand for pesos to purchase that good will increase, while the demand for the good in the United States and the demand for dollars will decrease (Moffat 2011). According to the concept of absolute purchasing power parity, this will continue until the good has the same cost in both countries, and the exchange rate will be equal to the ration of peso cost to dollar cost (Moffat 2011; Antweiler 2011). In reality, this theory does not really perform that well due to a variety of factors -- shipping costs, tariffs, regulatory/quality issues, etc. Relative purchasing power parity asserts that the rate at which two currencies move towards equality in purchasing power is derived from a comparison of their inflation rates: the difference in this rate is the rate at which the currencies are approaching parity in purchasing power (Antweiler 2011). This version of the concept has proven to be far more empirically applicable than the absolute form of purchasing price parity, still asserting that purchasing power should be equal but acknowledging that it very rarely is, and that currencies are usually overvalued or undervalued in comparison with each other (Antweiler 2011).

An examination of the relationship of purchasing power between the United Kingdom and Sweden can give some illustration of the strengths and weaknesses of these two different forms of purchasing power parity theory. Currently, the PPP adjusted GDP per capita in Sweden is 4.55% higher than in the United Kingdom in terms of purchasing power parity, meaning Swedish consumers should be able to buy 4.55% more goods (generally speaking) than their UK counterparts (IIWMH 2011). The current exchange rate between the GBP and the Swedish Krona (SEK) is 10.26 (1 GBP = 10.26 SEK), meaning this should also be the expected ratio between the price of the same good in both countries (CoinMill 2011). A comparison of the consumer price indices of both countries, however, reveals that goods are actually about 1% cheaper in Sweden than in the UK, meaning there is a difference in purchasing power that cannot be accounted for in the absolute model (ONS 2011; SCB 2011; Antweiler 2011). Relative purchasing power…

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