My colleague Charles Engel has a new paper circulated by the Dallas Fed entitled “Exchange Rate Policies”, which brings theory to bear on the topic. From the introduction:
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 [1]).
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.
For previous entries on equilibrium rates, see: [2], [3]m, [4].
Thanks Mr Chinn for the link to Mr Engel’s paper (and more broadly for you blog). I agree with Mr Engel’s conclusions but for very different reasons. It surely is difficult to assess what is an equilibrium exchange rate as I have stated several times before (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1103427 for example for the China US exchange rate), and the task is even harder for developing economies. But I wouldn’t oppose the 60’s models of exchange rate based on trade balance to the 90’s models of Obstfeld-Rogoff et al. Mr Engel seems to underline that equilibrium models have (at least) two problems: data limitations (this issue is well-established in my view and very accurate) and are based on “old fashioned economic modelling”, this issue is more debatable for the following reasons:
1. Even in old-fashioned models the exchange rate can be described as an asset price and you can model bubbles as well. See articles in the Dornbusch tradition for example.
2. In my opinion, equilibrium exchange rate models (FEER and BEERs) have flaws that depend:
a) on the lack of modelling of the internal equilibrium (unemployement, output-gap and prices in general) and economic policies
b) the lack of empirical content for “sustainable trade balance” or “desired net foreign asset position, as evinced by Mr Engel
It is true that floating exchange rate have not been able to reach external equilibrium or what I called “macroeconomic efficiency” (see “Through the Looking-Glass: Reconsidering FX Market Efficiency” http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1483493) and analysing micro factors such as currency pricing are a very promising route for addressing this issue
Regarding Mr Engel point 3 (Target for Exchange rate for emerging economies), a way to assess this value could rely on modelling authorities objectives (for example China wants high foreign demand for goods to decrease unemployment)…
“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.”
The myriad factors that prevent Chinese factory workers from coming to the US to get the higher wages they could get here create more a little stickiness.
There is an enormous amount of stickiness out there. A theory that assumes stickiness is insignificant is for most practical purposes worthless.
Since I’m not an economist, and actually have a marginal propensity for playing golf and tennis, I’ve simply employed Occam’s Razor and concluded that there is no such thing as “equilibrium exchange rate”. It is a total myth.
It is mythical because of the time lags(ok, call it stickiness) for the economies and bilateral exchange rates to sync up and achieve “equilibrium”. Because of the time lags the swings needed in either exchange rates or the economy are too large to handle, by one party or the other, so they resist. Also, the exchange rate policy works unevenly on the economy(ie strong oil-ruble was bad for Russian automakers). The other problem in today’s world is that financial flows may even dominate trade flows, making exchange rate policy or meaningful floating rates difficult to implement.
This all makes me think they are targeting the wrong variable. If you want trade balance, target trade balance directly. One idea along these lines that made sense was where Warren Buffett proposed a trade voucher system. Trading partners must earn vouchers by importing things, then they are allowed to export(I guess this is managed at government level). For instance, China would have had to buy Boeing aircraft rather than Airbus in order to sell toaster ovens to Wal-Mart. Of course the interesting question here is what would China claim the exchange rate is under these new rules? And do floating rates in general take care of the price question?
It seems to be an implication of the premises of this paper that one could use relative levels of purchasing power to explain at least long term price fluctuations of the Japanese Yen vs. other currencies. Is there any empirical validity to that idea?
I’ve come with a question, which is not overtly associated with this exchange rate article.
Please forgive that and consider giving an answer?
I’m wondering of wealth generation within the context of the U.S. Govt. Specifically can it be determined conclusively there is no wealth generated by the U.S. Govt.? My expectation of the answer is to include such variables as infrastructure, subsidies to myriad public and private businesses, and in a way it seems that being the largest employer there is huge demand created by all the income of federal employees?
The argument I’ve seen and disagree is that the Fed Govt. in no way can be equated to creating wealth. This doesn’t seem logical, but if you could give insight…?
It would be interesting to plot on the same time us euro areas business cycles to probe test ME. I notice as well Keynes is given no word on the interest rates differential,inflation, balance of payment.
Markets do as usual give no chance to anyone but their own (please see the OOCC derivatives report)
As an aside statistics would show that many banks on a 10 years pure speculative Forex activities show zero profit (after separation of the profits derived from commercial,customers orders)
The paper doesn’t say much about the overriding issue – should China be allowed to continue to accumulate foreign reserves in the face of the dirth of global aggregate demand. It might go some way to justifying the policies of oil exporters to prevent large short-run currency realignments that would come from large oil price changes.
Overall, I don’t think there is much substance to the paper.
He’s got it right that real exchange rates are what matter, not nominal exchange rates. The real exchange rate is identical to the relative value of (all kinds of) labor in two different currency zones.
Where he’s wrong is in stating that managed or fixed exchange rate policies shoudn’t effect real exchange rates in “perfect markets”. This is thoughtless nonsense: if you have a managed or fixed exchange rate, you obviously don’t have a perfect goods market. The mechanisms by which governments manipulate nominal exchange rates inevitably distort goods markets and real exchange rates.
I think Tom must be right. When a government holds its currency artificially low, it sends its own (non-market) price signal. I think this type of policy forces domestic consumers of imported products to subsidize exporters.
Chapter 16 of Peter Montiel’s “Macroeconomics in Emerging Markets” serves as a great primer on exchange rate misalignment for those who want a cursory overview on the subject.
You can read excerpts here:
http://books.google.com/books?id=ShobukedfBwC
“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.”
The myriad factors that prevent Chinese factory workers from coming to the US to get the higher wages they could get here create more a little stickiness.
There is an enormous amount of stickiness out there. A theory that assumes stickiness is insignificant is for most practical purposes worthless.
“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.”
The myriad factors that prevent Chinese factory workers from coming to the US to get the higher wages they could get here create more a little stickiness.
There is an enormous amount of stickiness out there. A theory that assumes stickiness is insignificant is for most practical purposes worthless.