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Money and exchange rates

Posted by
February 18, 2015
in Blog

The new year started with much media attention to exchange rates between currencies of some countries versus their trading partners. The Swiss got things started by announcing an end to the artificial peg of their currency—francs—and euros. The consequent dramatic rise in the exchange rate between francs and euros caused sudden and often very large windfall gains and losses to lots of people.

Meanwhile, the Russian ruble continued to drop in value against the euro, dollars, yen and other currencies, all while the European Central Bank and the Bank of Japan continued to pursue policies intended to reduce value of the euro and yen against other currencies. Casual readers of press reports would learn that the Russian people are being harmed by the falling value of their currency, but the central banks of Europe and Japan want to help their people and their economy by reducing the value of their currencies. Does that make sense to anyone?

While all that has been going on in other countries, press reports in the US say that US companies are being harmed by the rising value of the US dollar versus other countries. To sum up, it would seem that Russians are being hurt by a weak currency while Americans are being hurt by a strong currency, at the same time that the Swiss are benefiting from a strong currency and some central banks want to weaken their currencies to help their citizens. Is that clear enough? Would most readers know whether Greek citizens would be better or worse off if the country went off the euro and returned to drachmas that fall in value compared to other countries?

Actually, the subject of exchange rates between various types of monies is not very complicated if a few principles are kept in mind. People in every modern economy buy things from, and sell things to, people in other countries. How much they have to pay when they buy and how much they can get when they sell depends on the exchange rate between the domestic money and the money of the other country. There is only one exchange rate between any two currencies and it depends on many things, including the inflation rates of each country and “acts of God”in one of the countries. Wealth gains and losses in one country can result from changes in the exchange rate caused by developments in the other.

When international terms of trade are altered by foreign developments—wars, agricultural conditions, etc.—there are redistributional effects in the domestic economy: The effects on import-competing firms is opposite to that on exporting firms, and the prices of tradable goods change relative to the prices of non-tradable goods. Furthermore, asset prices are influenced differently than goods prices. If a rising US dollar looks like a good investment opportunity to foreigners, they will contribute to the bidding up of common stock prices, real estate prices and other assets priced in dollars.

In all, many prices are affected, in different directions, with some people being positively or negatively affected relative to other people. None of these developments, though, has any certain effect on the stability of the domestic currency. Even though price indices that include foreign goods—and domestic goods that compete with foreign goods—may increase or decrease as a consequence of international developments, it is not correct to identify such statistical observations as inflation or deflation. A shortfall of the coffee crop will influence coffee prices in importing countries. And, to the extent consumers pay the higher prices, they will experience a real income loss and consequently will purchase less of other things. What is observed is the higher price of coffee in the price statistics. What is not so readily observable is the associated lower demand for, and prices of, other things compared with what otherwise would have occurred. Relative prices have changed, but the average of prices depends on the income and substitution effects and the choices people make.

It is common—but wrong—for someone to say that “inflation is rising because higher costs of imports such as oil (or coffee, or any other imported products) is raising the cost of living.” More recently, the falling price of oil has been incorrectly cited as a source of “deflationary pressures.”Hand-wringing over the plight of companies and workers in oil producing countries and regions, while neglecting the gains to households with more money left over after filling the tank, is clearly a one-sided story. The same is true for big changes in exchange rates—there are benefits to some and losses to others, and none of it has anything to say about inflation or deflation.

However, it is true is that misinterpretation by policymakers of a “price shock”caused by a change in the external exchange rate or by a real event such as a sudden drop in oil prices can result in mistakes in monetary policy. Overt monetary stimulus to counteract perceived deflationary pressures, or overt monetary restraint of combat perceived inflationary pressures, can result in unintended monetary inflation or deflation. Recent history offers many such misinterpretations and policy mistakes that have resulted in inflations (and deflations) that could have been avoided.

Russian people who buy foreign goods now pay more for them—but that is not inflation. Russian producers of vodka now sell more because the price to foreign consumers is lower. Swiss citizens now pay less for goods imported from euro countries—but that is not deflation. Foreign tourists to Switzerland will now pay more—but that is not inflation. The US is now a more expensive place for foreigners to visit, while American tourists to Europe will enjoy lower prices. Such gains and losses cannot be avoided in a world of fiat currencies managed by central banks; policymakers should resist the temptation to interfere (or intervene) in such markets.

2 Comments

  1. TwoWheelerInsurance August 9, 2016 6:07 AM

    People in every modern economy buy things from, and sell things to, people in other countries. How much they have to pay when they buy and how much they can get when they sell depends on the exchange rate between the domestic money and the money of the other country.

  2. Tim Ozenne February 20, 2015 7:03 PM

    Any idea how we should measure inflation, allowing for quality changes?