Arnold Kling  

The CEA on Exchange Rates

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From the 2007 Economic Report:

the Chinese intervention does not systematically change the relative real prices between the United States and China. Had the Chinese government not intervened, Chinese domestic prices would have remained the same in terms of yuan and become more expensive in terms of dollars through a change in the exchange rate. With the intervention, Chinese domestic prices rose in terms of yuan and became more expensive in terms of dollars even though the value of the nominal exchange rate was unchanged. This outcome occurs any time a country takes actions to fix its exchange rate: fixing the nominal exchange rate does not necessarily have any impact on the relative prices between two countries. In other words, fixing the nominal exchange rate does not tend to move countries away from purchasing power parity. The only effect is that domestic goods prices have to do all of the adjustment since the exchange rate is fixed.

I think that what they are saying is that exchange rate policy is neutral because you only control the nominal exchange rate, not the real exchange rate, because the latter depends on prices. By the same token, you could say that monetary policy is neutral because you only control the nominal money supply, not the real money supply.

The traditional macro view is that prices adjust slowly, so that in the short run you do control both the real money supply and the real exchange rate. I would think that would make this chapter controversial. But I may be the one who has failed to keep up with professional thinking on the subject.

UPDATE: Menzie Chinn is up to date on professional thinking.

COMMENTS (4 to date)
Edgardo writes:

In the 1970s Lucas argued correctly that money was NOT neutral but this didn't mean that the central bank could CONTROL the real money supply. The same applies to nominal and real exchange rates: central banks have never been able to control real rates.

Arguments about the non-neutrality of money are very old and recent "professional thinking" on the subject has contributed nothing to what one could have learnt in the 1960s, a time of fixed exchange rates. If anything, macroeconomists are still trying to take advantage of the non-neutrality of money, but so far they have failed as shown by the Fed's response to the sharp increase in oil prices (they wanted to prevent the impact of a change in relative prices on the measured rate of inflation).

RWP writes:

I am interested in an online resource for FOREX futures contract rates. I have searched but no luck only adverts. Any reader suggestions?

Scott Wood writes:

How are domestic nominal prices set in China? Surely they were centrally set in Mao's time. Did Deng eliminate that?

Barkley Rosser writes:


Deng eliminated that. They are now largely set by market forces.

What is ludicrous about this part of the CEA report is that there has not been much inflation in China, not more than the US systematically. This is a bad case of someone in a policy position telling an ideologically driven story based on monetarism that is simply out of synch with the empirical data. It is a fairy story, and not one with a necessarily happy ending.

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