Re: Fixed vs. flexible exchange rates

[paul davidson <pdavidson@xxxxxxx>]

At 04:17 PM 4/28/03 , Henry wrote:
> 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.

According to the Able and Bernanke textbook (p.508) the explanation  for
the upward movement of the J curve above occurs when "we assume that the
time period is long enough so that the Marshall-Lerner condition
holds".  In other words, if the Marshall-Lerner condition does not hold for
the first few years (decades?) then the idea that depreciation of the
currency automatically solves the balance of payments  trade deficit
(import surplus) is a fiction of mainstream economics -- and its
restrictive gross substitution   axiom that in some reasonable time period,
everything is an excellent gross substitute for everything else so that
small changes in relative prices (a depreciation of the exchange rate in
this case) solves the problem if not immediately then , as Henry puts
it,  "in the first few months".  Ungfortunately, Henry, the lack of the
applicability of the Marshall-Lerner condition is a n important real world
fact -- except perhaps for some small economies whose major (almost sole)
export is a homogeneous primary product that can be produced in many places
around the globe (a condition close to the pure competition case of
classical economics).


>  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.


This may be but a further complication but is not as important as the
Marshall-Lerner problem.
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.

[Exceppt when the CB changes its interest rate policy to defend its
currency -- as for example the Bank of Englland tried to do against
george  Soros's speculation in the early 1990s.



The above  is a form of the interest parity mainstream solution -- if a
change in the interest rate does not directly affect the fx rate -- then
what?  The usual response of classical economist is that the risk of the
foreign currency change has increased.-- for example Japanese yen vs. US
dollar in recent years?


> 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.

Not necessarily!!


>  If the exchange rate is fixed too low,


too low according to what?

> 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.



Just as the Bof J does when it tries to prevent the yen from rising --
right ---)?


> 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.


Whatever happened to dirty floats?  Is there any country that will truly
let its currency float cleanly-- except in Milyon Friedman's
Alice in Wonderland?  Really is not most countries today on a managed
float? And Why do they prefer that than the efficient solution of a clean
float?  Are they stupid????

  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.


WHY???? Stupidity????

paul

Paul