Exchange rates and adjustment: What does it mean?

With the mass of recent discussion on the exchange rate and the “structure” of the economy (here, here, here, and here) it seems like a good time to discuss exactly how the exchange rate matters insofar as discussing the economy.  Luckily for us, Paul Krugman has already done an excellent job of this.

New Zealand has moved away from looking at monetary stimulus persee and is currently thinking about the “sustainability of growth” moving forward.  Given our large foreign debt position, our seemingly persistent trade deficit, and the large share of real GDP made up of consumption goods and residential investment there are justifiable concerns about the nature of New Zealand economic growth going forward.

Given that prices denominated in local currency are slow to move, the higher the New Zealand dollar is, the relatively cheaper to import something then to buy it from someone in New Zealand.  As a result, if New Zealand runs a trade deficit in the short-term one reason may be that the dollar is too high.

The flip-side of this is that if New Zealand appears to be running persistent trade deficits, and running up a growing stock of debt, then there may be downward pressure on the exchange rate.  A lower exchange rate would then increase the cost of bringing in imports and lead NZ to making a relatively larger amount of its stuff at home.

This often leads to the conclusion that we need to lower our dollar in order to deal with what appears to be an unbalanced economy, but …

But?

The exchange rate is not some lever that we fix in order to get outcomes – it is a price, a price that is determined by the (relative) supply of and demand for New Zealand currency.  If our Reserve Bank is setting interest rates in order to keep inflation expectations anchored at its target level (approximately 2%) but we have “imbalances” then we have to ask why.

After all, if price growth is known to be 2%pa (on average) economic growth is known to be 2.5% (on average) and interest rates are set in conjunction with these expectations then the value of the exchange rate should (on average) represent the balance of prices (and expectations of other variables) between different economies.

If the dollar persistently differs from this level, and the nature of economic activity appears unbalanced, then it indicates that there are structural issues either inside the economy or externally – the exchange rate is a price, it acts as a signal not as the cause of issues.

As a result, if the exchange rate is not “adjusting” in the way it “should be” we need to ask why.  Is it because:

1. Other countries are trying to suppress the value of their currency (as suggested here, here, here, and here),
2. Households and businesses are taking on too much debt,
3. Government policy is creating a wedge between the private and social benefits of individual actions.

If we can figure out what factors are driving the imbalances in our economy then we can come up with policy changes to improve outcomes.  Arbitrarily changing monetary policy so that we reduce the level of flexibility in our exchange rate is not the way to go.