Friday, January 15, 2010

Floating Exchange Rates And Prices

It is no mystery why developed countries abandoned fixed rates. By anchoring the currency, governments forced the real economy to absorb shocks. This implied wage cuts or higher unemployment, all for the benefit of creditors. But in a democracy the votes of debtors tend to overwhelm the interests of creditors.

Interesting analysis, but something about it doesn't sit right with FLG. This passage feels problematic:
Freed from the need to defend their currencies, and with consumer inflation a minor problem over the past 20 years, central banks could afford to let interest rates drift steadily lower.

Buttonwood's analysis all makes sense. Short-term currency prices are determined, as FLG has mentioned many times before, pretty much by interest rate parity. Long-term, it's about purchasing power parity, or the differing rates of inflation between the two countries.

The standard model for thinking about international macroeconomics is an IS-LM-FE model, where IS is the real economy, LM is the money market, and FE is the foreign exchange market. Thanks to Walras' Law, we know that if two of these markets are in equilibrium, then all of three of them must be. (FLG thinks it holds for N markets, but he's not sure.)

FLG will have to think about this more. There's something about foreign investment still coming in even as interest rates stay low that seems wrong. If you bring in other factors, like the lack of a broad and deep financial market in places like China, then it might start to make more sense.

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