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Misconception #1: When to use Marshall Lerner

Condition (MLC)?

Many of you have been taught in school that when exchange rate changes, the
effects on the trade balance will depend on whether the MLC holds.

You are taught that if the MLC holds (i.e. PEDx + PEDm >1) then a appreciation of
the currency, ceteris paribus, the trade balance would worsen. And conversely
if the currency depreciates, ceteris paribus, the trade balance would improve.

This is correct. But remember that you should not simply state this idea during
the examination. Instead, please explain it.

Also, some of you have been taught that (for depreciation) other than the ceteris
paribus assumption, you also need to assume that the PES of firms producing
exports is greater than one, otherwise even if foreign households want to buy
more from our local firms, these firms wouldn't be able to produce more.

This is strictly speaking not necessary. All that is needed is that the PES is
sufficiently large to allow whatever additional units that foreign households wish
to buy (as a result of the depreciation of the local currency) to be produced.
During the A levels exam, you are not expected to say this but it will gain you
credit if you claim and then EXPLAIN it.

Finally, many of you are taught (and your teachers insist) that when the local
currency depreciates, AD rises only if MLC holds. THIS IS DEFINITELY NOT

Recall that the AE or AD function was derived from the circular flow by
measuring all expenditure (hence aggregate expenditure).

Remember that in the circular flow, after households earn the income (Y), the
first leakage is taxess (T), leaving behind disposable income (Yd); the second
leakage is savings (S), leaving behind consumption (C), and the final leakage is
import expenditure (M), leaving behind consumption expenditure ono
domestically produced goods (Cd).

Thus the total revenue earned by ALL local firms is given by

Revenue = Cd + I + G + X

Where I, G and X are respectively revenue earned by local firms selling stuff to
other local firms, to local government as well as to foreigners (be they
households, firms or government).

Now since revenue (from selling goods) across ALL firms in an economy must
equal to the total expenditure by everyone (whether they are part of the

economy or not) who bought these goods, then we can write that Revenue = AE

So AE = Cd + I + G + X where C is TOTAL consumption expenditure by local
households on locally produced goods.

If you are still not convinced that M doesnt exist in AE or AD, then check this out:



We then have to subtract imports of goods and services (M) from the total in
order to leave just the expenditure on domestic product. In other words, we
subtract the part of consumers expenditure, government expenditure and
investment that goes on imports. We also subtract the imported component (e.g.
raw materials) from exports.

It clearly implies that
1. C = Cd + Cm
2. I = Id + Im
3. G = Gd + Gm
4. X = Xd + Xm

Now most of your schools (as well as my notes) teach you a simplified version
where we assume (for simplicity only) that I, G and X components are all
domestic only, so that implies that C = Cd + M.

So we can now rewrite the AE or AD as

AE = Cd + I + G + X + M M

Rearranging, we have

AE = Cd + M + I + G + X M

Or simply

AE = C + I + G + X - M

So actually, M does not appear in AE or AD at all.

THUS, when exchange rate changes the only direct effect on AE or AD is through
X. When exchange rate say falls (i.e. depreciates) the price of local exports DID
assume ceteris paribus. It only becomes cheaper in foreign currency terms. Thus
foreigners buy more (Law of Demand). Whether they buy a lot more or a little
more depends on the value of PEDx. But regardless of that values they WILL BUY
MORE. So X must increase.

Does M actually play any part here?

M as in import expenditure? NO!
Pm as in price of imports in local currency terms? Definitely yes.

Now let me explain:

If the currency depreciated, it means that imports become more expensive in
local currency terms, i.e. Pm rises.

Remember that there are local firms that produce substitutes to these imports
(although perhaps not too many for the Singapore context). So if imports become
more expensive, the DEMAND for these locally produced import-substitutes will
rise and thus Cd must rise.

Thus AD rises when exchange rate falls. Notice that there was no MLC needed in
any of the analysis? Notice that we did not even have to assume anything about
PED values at all.

If your teacher continues to insist, show this to your teacher, and ask your
teacher to mathematically prove this to be wrong, if they can.

Common Misconception #2: Definition of YED and XED

Many of you are taught (in your school notes) that the definition of YED is

the degree of responsiveness of DEMAND for a good to given change in the
income of consumers, ceteris paribus.

This is CORRECT.

But sometimes, in some textbooks as well as in my notes, you are taught that the
definition is

the degree of responsiveness of QUANTITY DEMANDED of a good to given
change in the income of consumers, ceteris paribus.


BUT some of your teachers insists that the second one is wrong. Actually
different text book use different definitions for this concept because both are
actually correct.

When income changes, it is DEMAND that changes, so the first definition is
correct. The reason why the second one is also correct is that any change in
demand is also equal to a change in the QUANTITY DEMANDED AT ALL PRICE
LEVELS. Also, the formula given by ANY textbook regarding this concept is
always percentage change in quantity demanded divided by percentage
change in income.

Thus both are correct. However, if your teacher for whatever reason insists that
the second one is wrong, I suggest that you write the first definition for your
examinations BUT do not as a result begin to think that only one of them is

The same applies to the XED concept.

Common Misconception #3: What is the net effect on real Y

when exchange rate changes?

As discussed in Common Misconception #1, when exchange rate changes, AD
changes due to X and Cd, so please dont bring in MLC again.

So when exchange rate say appreciates, (as is the typical stance of the MAS), AD
falls. This is shown as a leftward shift of the AD curve and through the multiplier
process (please explain this in detail during exams) real Y will fall by a multiple.

But as you all know, the stronger currency also makes imported final goods, raw
materials and semi-finished goods all cheaper to local firms importing them.
Local firms may import final goods (like iPhones and Samsung phones) to sell at
retail shops, so this represent a fall in costs of production (COP) for these firms.
Other firms import semi-finished goods and/or raw materials to add value or to
produce other goods. Thus, the appreciation also implies that their COP falls.

Now since, we assume ceteris paribus, all else must be equal, including factor
productivity, so unit COP should fall across the economy. This translates into a
downward (or rightward if your prefer) shift of the SRAS curve. (For those of you
drawing the single combined AS curve, this means that the upward sloping
portion of the AS curve shifts downwards while the vertical portion, or Classical
range, does not move).

This down (or right) shift in SRAS (also called an increase in SRAS, I know its
confusing) then causes real Y to rise. (This is shown as a movement along AD and
explained using the ideas of wealth effect, interest effect and trade effect).

So the final question is of course, what will be the final effect on real Y?
For those of you who still don't see the point of this question, let me SPELL IT
OUT for you. The right shift in SRAS causes real Y to RISE while the left shift of
AD causes real Y to FALL, so we need to consider the NET EFFECT.

To deal with this, let us first assume a country whose output is made ENTIRELY
with imported semi-finished goods and raw material, i.e. goods produced locally
have no domestic inputs at all. I know that's unrealistic but Im counting on it to
be unrealistic.

So with the appreciation of say 10%, foreign inputs become cheaper by exactly
10% in local currency terms. Now since we unrealistically assumed that all goods
produced in the country uses only foreign inputs, then ceteris paribus, it must
mean that unit COP must have fallen also by exactly 10%. This must mean that to
the foreigners, our exports now costs exactly the same as before the currency
appreciation. So X doesnt change.

However, if more realistically, the output of the country is produced not only
entirely with imported inputs, but also some local inputs, then inputs prices
cannot account for the entire COP for local goods. So a 10% fall in prices of

foreign inputs would result in a less than 10% decrease in unit COP. Thus for
foreigners, our exports would still end up being slightly more expensive and X
would still fall.

This means that the left shift of the AD dominates the right shift of the SRAS so
that real Y ultimately falls when the currency appreciates, ceteris paribus.


Now some of you sharper people will say that hey didn't Cd also fall?
Youd be exactly right to remember that. But recall also that Cd fell because the
appreciation made imports cheaper (i.e. Pm fell by 10%, and demand for locally
produced substitutes of those imports would fall, the extent to which of course
depends on the XED between local and foreign goods).

The appreciation also made imported inputs cheaper and thus the unit COP for
these locally produced goods cannot have stay constant. In fact they must have
fallen too. But as long as the import content of these goods is 100%, i.e. they are
produced entirely using imported inputs, then unit COP must have fallen by
exactly 10% thus offsetting any change in relative prices between foreign
imports and their local substitutes. Thus any change in Cd initially would be
cancelled out. But since import content cannot be 100%, at least not for all these
goods, imports prices would still have to fall more than the prices of their locally
produced substitutes and so Cd must still fall.

As such the conclusion doesnt change:

Ceteris paribus, an appreciation of the domestic currency shifts AD to the left and
SRAS to the right and the resultant effect on real Y is negative. There is no
elasticity assumption in the whole analysis. The only assumption that is needed,
and it is one that does not have to be made explicit since it is obvious, is that the
import content of a countrys goods cannot be on average 100%.

Common Misconception #4: When using an indirect tax to

correct a negative externality, does the tax itself causes a
deadweight loss?

The short but not precisely correct answer is NO. The more precisely correct
answer is that it depending on whether the government had set taxes to high.

In early chapters, when you are taught about indirect taxes and subsidies, there
is always a deadweight loss. This was when you were not taught market failure
yet. So the assumption, which is sometimes not made explicit in your schools
notes, is that the free market equilibrium output (i.e. the quantity transacted at
equilibiurm) originally was a socially optimal outcome. The imposition of an
indirect tax or subsidy would shift the supply curve vertically up or down
(depending on whether it was a tax or a subsidy) and thus cause the market to
adjust to a new equilibrium output.

This new output is caused not by a change in either consumers tastes and
preferences or income or by changes in costs of production, and as such is a
DEVATION FROM THE SOCIAL OPTIMUM. Thats why there is a deadweight

So the point is that a deadweight loss only occurs when the market outcome
(whether by free market or as a result of government intervention) is different
from the social optimum.So in the case of a negative externality, the free market
outcome is already higher than the social optimum, hence there is over-
consumption (or over-production depending on whether it is a consumption
externality or a production externality).

The imposition of an indirect tax is aimed to bringing the market outcome
towards the social optimum, thereby reducing the deadweight loss. If
successfully applied, the indirect tax would bring the market outcome to where
the social optimum is thereby completely eliminating the deadweight loss due to
the externality. And since the market outcome now is at the social optimum
(albeit due to government intervention) there cannot be anymore deadweight

Thus, if imposed correctly, the indirect tax that is used to correct the market
failure caused by a negative externality does not on its own cause another
deadweight loss.

If however, it was set too low and the resultant market outcome is still above the
social optimum, then a deadweight loss still exist, but then it would still be the
result of the negative externality and not caused by the indirect tax.

But if the government had set a atx too high and caused the market outcome to
be now lower than the social optimum, a new deadweight loss emerges. This
time it is due to the under-consumption due to over-taxing the good. Then the
new deadweight loss is caused by the tax.

Common Misconception #5: Money Supply versus Supply of

Money in the FOREX Market

Loosely speaking, money supply refers to the amount of money in circulation. To
be exact, this is more than just physical currnecy that is in circulation. It includes
bank deposits that people maintain at their banks. In general we make a
simplifying assumption that the Central Bank controls the money supply in an
economy. Suppose the Central Bank say the Federal Reserve wishes to increase
money supply, what it does is that it will buy US government Treasury bills from
US banks. It pays the banks with US Dollars that it printed. As a result, the money
supply in the US economy rises.

The supply of US Dollars in the FOREX market however refers to the amount of
US dollars put up (by anyone wishing to sell USD in exchange for some other
currency) in the FOREX market. In a rough sense, this is a subset of the money
supply. Changes in the suppy of USD in the FOREX does not mean that the money
supply in the US economy must change as well. If however, the supply of USD in
the FOREX market changes BECAUSE the Central Bank sells it in the FOREX
market, then the money supply must also increase.

So the point is that whenever money flows out of the Central Bank, whether
through the bonds market (i.e. Central Banks buys T-bills) or through the FOREX
Market (i.e. Central Banks buys foreign currency), the money supply increases.
This is because any money put out by the Central Bank was not previously in
circulation and was therefore not money supply to begin with. After injecting it
into the econom, it becomes money supply.

Correspondingly, any changes in the FOREX market triggered by changes in
private sector actions, be it via demand or supply, does not change the money
supply since no money flowed into or out of the Central Bank.

Common Misconcpetion #6: Hot money versus Investment

versus FDI and how changes in interest rate affects them

When interest rate changes, say it falls, we say that investment rises. This is
because at a lower interest rate, the cost of borrowing falls, i.e. it becomes
cheaper for firms (in the country) to borrow money. Assuming that the expected
rate of return of investment did not change in the economy, the expected net
return on investment should rise and thus firms would be induced to invest
more. This is typically represented as a movement along the MEI curve.

FDI, particularly inward FDI, is investment that comes into the economy from
overseas. Typically, we assume that it is difficult for foreign firms to borrow
money a country in order to invest in that country. As such, the interest rate in
the host country matters little to FDI. It is the interest rate in the home country
that matters more.

Hot money on the other hand isnt really investment. It is the savings or pension
funds of foreign households that are looking for a better return (i.e. interest rate)
than what they can get by parking their money in their local banks. When a
countrys interest rate falls, hot money flows out of the country in search of
higher returns (interest rate).

Often students are confused as to why when interest rate falls, investment rises,
but hot money flows out. This confusion stems from the incorrect understanding
that hot money is in some sense, investment. It isnt.