Random thoughts of an economist

Containing the monster of inflation!

Posted in China, Economics, Exchange rate, Forecasting, Nguyen Phuong Thuy, Trade balance by kafuwong on February 17, 2011

[Written jointly with Nguyen Phuong Thuy]

Experiencing a global quick recovery, Chinese economy is beginning to over-heating (relatively high economic growth and inflation). It is reported that the country attempts to control inflation by increasing the interest rates and let their currencies appreciate. (http://www.bloomberg.com/news/2011-02-08/china-raises-benchmark-one-year-deposit-lending-rates-by-25-basis-points.html)

How do these tools help contain inflation?

To simplify the discussion, let’s imagine that China produces only widgets.  Then, inflation will simply be the percentage change in the price of widgets.  A rapid increase in the price (a high inflation, in other words) is driven by an increase in demand or decrease in supply.  To contain inflation, one must reduce the speed of increase in demand or the speed of decrease in supply.  Interest rate is a cost of consuming and investing today instead of tomorrow.  Thus, raising the benchmark interest rate encourages people to reduce their demand for consumption and investment today.  Thus, a higher interest rate will lower the demand or reduce the speed of increase in demand.  (Of course, since interest cost is a cost of production, a higher interest rate will also raise the cost of production and therefore reduce supply.  However, the impact of interest on supply curve is usually relatively negligible relative to its impact on demand.)

The higher interest rate or yield will also make domestic assets more attractive to foreign investors. IF China’s currency is perfectly convertible, we would expect a higher demand for RMB by foreigners, resulting in an appreciation of the RMB.  Consequently, Chinese exports become more expensive to foreigners and imports from foreign countries become cheaper to Chinese firms.  This reduction in foreign and domestic demand for Chinese products will further reduce the demand for widgets. 

Of course, China’s currency is not freely convertible.  Consequently, to reduce the demand for widgets from the foreign trade sector, the government has to revalue (or appreicate) its currency.  

          China is not alone in dealing with its overheating economy.  Other economies in the region also raise their rates in order to keep inflation as targeted. The deposit rates first announced in Feb 2011 of the top bank deposit accounts in Asia can be found at http://asia.deposits.org/ .

          How long it takes for these effects to work, on the other hand, depends on how the quick economic agents in the economy respond to the change in the interest rates, for example, how consumers change their decisions over spending and savings. Therefore, we should expect the size of timing to be different in different economies.  Nevertheless, full effect of monetary policy like this is expected to take about one to two years.  

History tells us that rate hikes are usually higher serially correlated (a rate hike tomorrow is more likely if there is a rate hike today).  So, one would expect more rate hike to come. 

Let’s wait and see.

Minimum wage legislation as a tool of income redistribution?

Posted in Economics, Hong Kong, Minimum wage, Nguyen Phuong Thuy, Regulation, teaching by kafuwong on October 29, 2010

[Written jointly with Nguyen Phuong Thuy]

Although most economists believe that free market is most efficient, a lot of markets remain regulated.  Labor market is among the most highly regulated.  Most countries have implemented minimum wage.

Hong Kong, the freest market economy, (http://www.heritage.org/index/country/HongKong), is setting a minimum wage in its labor market as an effort to reduce poverty, income disparity and to achieve social stability. The city passed its first-ever minimum wage bill on July 15, 2010, after a long and heated debate among legislators.

The government says the minimum wage will benefit more than 18% of the city’s population who are living in poverty and boost consumer spending. The legislation is also expected to help narrow the rich-poor gap.

At the time of writing, the level of minimum wage is being finalized.   The Labor Union wants at least $33 per hour.  A group of employers say they can only afford hourly wages in the range of $24 to $25, and that any high floor will lead to layoffs and even push them into bankruptcy.

Honestly, I fail to understand why the minimum wage legislation helps underpaid workers in aggregate.  We can understand that the legislation may help the currently underpaid workers to earn more. However, an underpaid person will bring home more bread only if he continues to be employed under the new legislation.  The problem is that the competition in Hong Kong is so keen that small and medium enterprises can barely survive.  The legislation will raise cost and consequently reduce profit.  Chances are that some marginal companies cannot survive under the new legislation and will have to close.  Chances are that some marginal companies will reduce labor usage.  In short, employment will suffer.

Who is the most likely to lose their jobs? Those who were previously paid well below the minimum wage! If wages are proportional to productivity, we can imagine that the most unskilled, disabled and elder workers, who are supposedly intended beneficiaries of the legislation, will suffer the most.  Their suffering is due to the loss in employment!

Of  course, these people will most likely fall into the social security safety net, adding to the burden of the government, and hence the taxpayers.  In this sense, the minimum wage legislation is an indirect way of redistributing the wealth from the rich to the poor.  [Of course, the follow-up question is whether this way of redistribution is better than its alternatives.]

The extent of the legislation’s impact is an empirical issue.  In the next few years, we need to watch the figures of employment and figures of social security recipients closely.

[Jointly written by Nguyen Phuong Thuy and Ka-fu Wong]