Re: Fixed vs. flexible exchange rates

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

J CURVE expresses a relationship that exists between the exchange rate
for a nation's currency and its balance of trade. In principle, the drop
in a nation's exchange rate, or price of currency, makes the currency
less expensive to "buy." With "cheaper" currency the price of domestic
production is less and the price of foreign stuff is more, causing an
increase in exports to other countries and drop in imports coming in
from foreign producers. The economy thus moves in the direction away
from a trade deficit and toward a trade surplus. However, the first few
months after a drop in the exchange rate the balance of trade goes in
the other direction, with any existing trade deficit increasing or any
trade surplus shrinking. This occurs because the quantities imported and
exported don't change in the short run, but the prices do. Because more
is paid for the same amount of imported goods and receive less for the
same amount of exports, total spending on imports increases, total
revenue received from exports declines, and the movement is in the trade
deficit direction. Once those quantities start adjusting in the long
run, then we see a movement in the direction of a trade surplus.  But
this theory no longer works because of the nature of export contracts
has changed to compensate for the J Curve. Most export contracts now
include foreign exchange hedges, so that prices remain constant while
the value fluctuation is absorbed by the fx market - hedge funds and
currency traders.

FOREIGN EXCHANGE: Any financial instrument that gives one country a
claim on the currency of another country and which is used to make
payments between countries. The most important type of foreign exchange
is currency itself, that is, the currency of other countries. However
foreign exchange also includes things like bank checks and "bills of
exchange" (a sort of contract that's paid for with the currency of one
nation that can be then traded for the currency of another country).

EXCHANGE RATE: The price of one nation's currency in terms of another
nation's currency. This is often called the foreign exchange rate in
that it is the price determined in the foreign exchange market when
people buy and sell foreign exchange. The exchange rate is specified as
the amount of one currency that can be traded per unit of another.
Exchange rates are of course a function of interest rates of particular
currencies.  When central banks uses interest rate policy for managing
the economy, they are essentially changing the exchange rate of their
currencies.

FIXED EXCHANGE RATE: An exchange rate that's established at a given
level and maintained through government (usually central bank) actions.
To fix the exchange rate, a government must be willing to buy and sell
currency in the foreign exchange market in whatever amounts are
necessary. A fixed exchange rate typically disrupts a nation's balance
of trade and balance of payments. If the exchange rate is fixed too low,
then a government needs to sell it's currency in the foreign exchange
market, and may end up expanding the money supply too much, which then
causes inflation. If the exchange rate is fixed too high, then export
sales to other countries are curtailed and the economy is likely to
slide into a recession.

FLOATING EXCHANGE RATE: An exchange rate determined through the
unrestricted interaction of supply and demand in the foreign exchange
market. A floating exchange rate means that a nation's government is NOT
trying to manipulate currency prices to achieve some change in the
exports or imports.

 Structured finance in fact allows fixed exchange rates to behave like
floating rates and vice versa, but with the risks, benefits and
penalties shifted to third party investors.

  MANAGED FLOAT: An exchange rate that (like a floating exchange rate)
is free to move up and down, but is subject to government control (like
a fixed exchange rate) if it moves beyond certain boundaries. With
managed float, the government steps into the foreign exchange market and
buys or and sells whatever currency is necessary keep the exchange rate
within desired limits. The logic behind managed float is that an
unrestricted movement of exchange rates is usually pretty healthy, but
serious problems in the balance of payment and balance of trade result
if it floats too far in either direction.

This is in fact what every government does.

BALANCE OF PAYMENTS: The difference between the funds received by a
country and those paid by a country for all international transations.
The international transactions include the exchange of merchandise
(exports and imports), which is commonly summarized as the balance of
trade, plus the exchange of services, summarized as the balance of
services, as well as any gifts or transfer payments that do not involve
the exchange of goods and services. The balance of payments, in effect,
indicates the difference between currency coming into a country and that
flowing out of the country. The balance of payments is divided into two
accounts -- current account (which includes payments for imports,
exports, services, and transfers) and capital account (which includes
payments for physical and financial assets).

The balance of payment is the most manipulated account in international
finance.  The telecom industry is a good example, with IRUs books as
revenue and off shore special purpose vehicles, no one knows what is
really going on untill its too late.

BALANCE OF TRADE: The difference between funds received by a country
when exporting merchandise and the funds paid for importing merchandise.
The balance of trade is a major part of the current accounts portion of
the balance of payments. A balance of trade surplus results if exports
exceed imports, commonly termed a favorable balance of trade, and a
balance of trade deficit exists if imports exceed exports, analogously
termed an unfavorable balance of trade. The "favorable" and
"unfavorable" normative connotations attached to the balance of trade
rests with the presumption that a nation is "better off" when it exports
more than it imports, which is not necessarily true.

With electronic transfer of data, balance of trade becomes one of
changing definition.  Millions of IT jobs are transfered overseas
electrronically.  The annoucement you hear at JFK airport in NY is done
in India.

CURRENT ACCOUNT: One of two parts of a nation's balance of payments (the
other is capital account). It is a record of all trade, exports and
imports, between a nation and the rest of the world. The current account
is separated into merchandise, services, and what's called unilateral
transfers. The merchandise part is nothing other than the well-known
balance of trade. There's also a lesser known balance of services -- the
difference between services imported and exported.  This balance of
services in now bigger than the merchandise part.

CAPITAL ACCOUNT: One of two parts of a nation's balance of payments. The
capital is a record of all purchases of physical and financial assets
between a nation and the rest of the world in a given period, usually
one year. On one side of the balance of payments ledger account are all
of the foreign assets purchase by our domestic economy. On the other
side of the ledger are all of our domestic assets purchased by foreign
countries. The capital account is said to have a surplus if a nation's
investments abroad are greater than foreign investments at home. In
other words, if the good old U. S. of A. is buying up more assets in
Mexico, Brazil, and Hungry, than Japanese, Germany, and Canada investors
are buying up of good old U. S. assets, then we have a surplus. A
deficit is the reverse.

CAPITAL ACCOUNT SURPLUS: An imbalance in a nation's balance of payments
capital account in which payments received by the country for selling
domestic assets exceed payments made by the country for purchasing
foreign assets. In other words, investment by the domestic economy in
foreign assets is greater than foreign investment in domestic assets.
This is generally a desireable situation for a domestic economy.
However, in the wacky world of international economics, a capital
account surplus is often balanced by a current account deficit, which is
not generally considered a desireable situation. If, however, the
current account does not balance out the capital account, then a capital
account surplus contributes to a balance of payments surplus. The only
economy exempt from this rule is the US because the dollars role as the
preferred reserve currency for international trade.

CURRENT ACCOUNT DEFICIT: An imbalance in a nation's balance of payments
current account in which payments received by the country for selling
domestic exports are less than payments made by the country for
purchasing imports. In other words, imports (of goods and services) by
the domestic economy are greater than exports (of goods and services).
This is generally a not desireable situation for a domestic economy.
However, in the wacky world of international economics, a current
account deficit is often balanced by a capital account surplus, which is
generally considered a desireable situation. If, however, the capital
account does not balance out the current account, then a current account
deficit contributes to a balance of payments deficit.

INTERNATIONAL ECONOMICS: A branch of economics that studies economic
interactions among different countries, including foreign trade (exports
and imports), foreign exchange (trading currency), balance of payments,
and balance of trade. While much of the interaction among countries is
largely an extension of basic economic principles, complications do
arise because nations are distinct political entities, with different
laws and cultures, and with little or no overall governmental oversight.
The guiding principle in the study of international economics is
comparative advantage, which indicates that every country, no matter
their level of development, can find something that it can produce
cheaper than another country. The study of interational economics
focusses on two related areas -- international trade and international
finance.

INTERNATIONAL TRADE: The economic interaction among different nations
involving the exchange of goods and services, that is, exports and
imports. The guiding principle of international trade is comparative
advantage, which indicates that every country, no matter their level of
development, can find something that it can produce cheaper than another
country. International finance, the study of payments between nations,
is a related area of international economics. A summary of international
trade undertaken by a particular nation is given with the balance of trade.

INTERNATIONAL FINANCE: The economic interaction among different nations
involving the monetray payments and the exchange of currency. The
cornestone of international finance is foreign exchange, including
foreign exchange markets and exchange rates. International trade, the
study of trade between nations, is a related area of international
economics. A summary of international trade undertaken by a particular
nation is given with the balance of payments.

COMPARATIVE ADVANTAGE: The ability to produced one good at a relatively
lower opportunity cost than other goods. While pointy-headed economists
developed this idea for nations, it's extremely important for people. A
comparative advantage means that no matter how good (or bad) you are at
producing stuff, there's always something that you're best (or least
worst) at doing. Moreover, because you can produce this one thing by
giving up less than what others give up, you can sell it or trade it to
them. This idea of comparative advantage means that people and nations
can benefit by specialization and exchange. You do what you do best,
then trade to someone else for what they do best. Both sides in this
trade get more and are thus better off after than before.  IT only works
under full employment in all trading countries, as Paul always points out.

Much of these concepts needs to be refined or modified to reflect more
accurately current reality.  But it is hard because, current reality is
not fully known, partly beacuse the data collection regime has been
built on these obsolete concepts and partly because of lack of transparancy.

Henry C.K. Liu

paul davidson wrote:
> At 11:51 AM 4/28/03 , Henry wrote:
>
>
>> Warren Mosler wrote:
>>
>>> --- "Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx> wrote:
>>>
>>>> Paul is absolutely correct.  Further more, the
>>>> Mosler/Mitchel/Wray proposal does not deal with the froeign exchange
>>>> problem.
>>>
>>>
>>> ???  There is not foreign exchange 'problem' apart
>>> from fixed exchange rate policies, is there?
>>> Also, as per your other post, why would anyone want to
>>> force an exporter to spend his fx earnings???
>>
>>
>> Warren, we have been through this before. Under dollar hegemony, fixed
>> exchange rates require dollar reserves to hold. The Mundell-Fleming
>> thesis, for which Robert Mundell won the 1999 Nobel Prize,
>> states that in international finance, a government has the choice
>> between (1) stable exchange rates, (2) capital mobility and (3) policy
>> autonomy (full employment/low interest rates, counter-cyclical fiscal
>> spending, etc). With unregulated global financial markets, a government
>> can have only two of those three options.
>
>
>
> I think those with those who think that a flexible exchange rate is the
> problem and a flexible exchange rate is the solution -- suffer from a
> failure to understand the lack of Marshall -Lerner conditions in modern
> day international trade so that devaluation exacerbates the problem --
> as those who speak about the J-curve are implying for in the short-run
> the downward slope in the J is almost inevitable and -- you will note as
> I demonstrate in my book,it is assumed thatthe  upward slope of the J
> kicks in --in the longer run, the Marshall-Lerner condition kicks in.
>
> Of course it is the basis an excellent substitute for everything else --
> price elasticities are very large if not infinite.
>
> This assumption -- often implicit and therefore not specified --of high
> elasticities assures that a flexible price system will clear all markets
> at full employment -- at least in the long run -- when we are all dead.
> In the short-run interim in which we all live, there can be many
> painful, and perhaps even deadly,  income effects of flexible exchange
> rates.
>
> For a further discussion see my article "Are Fixed Exchange Rates the
> Problem and Flexible Exchange Rates the Solution?" in the Spring 2003
> issue of the EASTERN ECONOMIC JOURNAL.
>
> Paul
>
> Paul
>