A debate has continued over many years on the desirable degree of foreign
exchange rate flexibility. One side of the debate has sometimes
made the case that the exchange rate should be freely determined by market
forces, independently of any foreign exchange intervention or targeting
by central bank monetary policy. This argument takes the stance that the
market can best determine the appropriate level of the exchange rate.
From the standpoint of modern macroeconomics, particularly from
the view of New Keynesian economics, that stance is potentially selfcontradictory.
Markets are able to achieve efficient, welfare-maximizing
outcomes when they operate without distortions — that is, when markets
are competitive and prices adjust instantly to reflect underlying costs. But
in such a world, the nominal exchange rate regime is of no consequence in
determining the real allocation of resources. The real exchange rate (the
consumer price level in one country compared with the level in another
country, expressed in a common currency) and the terms of trade (the
price of a country’s imports relative to its exports) could adjust freely to
efficient levels under a floating nominal exchange rate regime, a managed
float, or even a fixed exchange rate regime if goods markets were perfectly
efficient. Nominal prices could respond to market pressures even if the
nominal exchange rate does not. In a world of perfect markets, relative
prices can allocate resources efficiently independently of the determination
of any nominal prices or the nominal exchange rate.
If the nominal exchange rate regime matters for the determination
of relative prices such as the real exchange rate or the terms of trade, it
must matter because there is some kind of nominal price stickiness. For
example, if the U.S. dollar/euro exchange rate is to affect any real prices,
it must be because there are some nominal prices that are sticky in dollar
terms and others that are sticky in euros. From the standpoint of modern
macroeconomics, the question should be posed: What policy best deals
with the distortions—from sticky prices and other sources? Is it a fully
flexible exchange rate, or some sort of exchange rate targeting? Moreover,
the relevance of an exchange rate policy is only for the “short run.” Once
enough time has passed for nominal prices to adjust to any economic
imbalances, the nominal exchange rate regime is irrelevant — the nominal
price adjustments can bear the load of relative price changes without any
help from the exchange rate.
The paper thus tackles the difficult question of what constitutes an equilibrium exchange rate, dispensing with the idea that the equilibrium rate is that which achieves the equilibrium in external balances (such as I have discussed previously ).
Figure 1: Log US real effective exchange rate (blue) and Euro Area real effective exchange rate (red), broad CPI deflated. Source: BIS.
The paper continues:
…I will discuss a different notion of external imbalance — an
imbalance in the level of the exchange rate. If global markets allocate
resources efficiently, then prices should reflect underlying resource costs
(costs of labor, technology levels, efficiency in production, etc.). The competitiveness
of firms should not depend on the nominal exchange rate. A
currency is misaligned when the exchange rate moves to a level where a
country’s competitiveness in world markets is altered. I will discuss how
currency misalignments can be inefficient even though exchange rates do
not have large short-run effects on trade balances.
This is required reading for those who want to think rigorously about what “currency misalignment” means.