Arnold Kling  

A Reason to Teach Macro

Conservatives, Libertarians, a... Charter Communities...

David T. King writes,

In Europe, the price of oil has risen by 50 euros in the past five-and-a-half years. It now stands at about 75 euros per barrel, three times what it was then. But in the U.S., the price of oil has risen to over $120 per barrel, and is now almost five times what it was then.

The sole reason for this enormous difference is the incredible depreciation of the dollar against the euro. From one for one at the end of 2002, it now costs nearly $1.60 to buy a euro.

...Exchange rates can be managed. We need exchange rate policy.

In order to know whether we need an exchange rate policy, one needs a theory of exchange rates. I'm not sure what theory of exchange rates I believe, but I find myself tempted to fall back on what I learned in international macro.

One of the things we learned was that you can use monetary policy to target the domestic inflation rate or to target the exchange rate, but not both. If we wanted to bring back parity between the dollar and the euro, then this macro theory suggests that we would have to cut back on the money supply considerably, probably enough to cause serious deflation. As a cure for high oil prices, that would likely be much worse than the disease.

Having said that, I have my doubts that we have a reliable theory of exchange rates. I have particularly strong doubts that we have a reliable theory of exchange rate intervention.

One might like a simple monetarist story in which the money supply determines the price level and in which relative price levels determine exchange rates. But the definition of the money supply is difficult to pin down in the modern world, and the purchasing-power-parity model of exchange rates barely can be made to fit in the long run, much less the short run.

Still, one should learn macro before reading (or dare I say writing) a piece that makes it seem as though exchange rate manipulation is a painless cure for high gas prices.

COMMENTS (9 to date)
Steven Vickers writes:

One of the things we learned was that you can use monetary policy to target the domestic inflation rate or to target the exchange rate, but not both.

My macro is admittedly hazy, but my impression is that you can do both of these, but not if you have open capital movements. In other words, capital controls would make this policy technically feasable(not that I endorse it!).

8 writes:

One should read King Canute first.

Arnold Kling writes:

That is the classic argument. Whether capital controls work is another thing I'm not sure about. Certainly they are not something the U.S. would want to try.

R. Richard Schweitzer writes:

Exchange policy?

What is "Policy?"

As used today does that term mean anything other than some setting the terms or objectives for conduct of others?

And who are the "some?" Whence do they come by that function?

Mr. Econotarian writes:

Perhaps we should go into monetary union with one of our major trading partners whom we import a lot from...

Lord writes:

Especially when so many other countries are manipulating their exchange rates.

Neal writes:
we would have to cut back on the money supply considerably, probably enough to cause serious deflation

Dear Arnold
Can you explain why economists are particularly scared of deflation? For example, why are inflation targets asymmetric (e.g. +2%) rather than zero? Inflation and deflation are both (equally?) bad, because of menu costs & corruption of price signals. But why is deflation worse? Are deflationary spirals any worse than inflationary spirals? Is it just inherited cultural fear of the great depression? Or a Phillips curve argument? I thought that while Phillips might work around an attractor point, it shouldn't be a basis for policy: the real issue was moving to a newer equilibrium (c.f. Ormerod Death of Economics)

Any enlightenment would be greatly appreciated.

Yours macro-economically confused

p.s. I'm not taking issue with your analysis of this issue - I accept serious deflation would be bad. But would it be worse than serious inflation?

michael gordon writes:

1) Agreed: there's no full-proof theory of exchange rate --- at any rate for a very large and rich national economy like the US's.

2) Such an economy --- only the euro-zone might approach it --- mixes (as Gregory Mankiw notes in his 6th and latest edition of Macroeconomics) the "behavior of a closed economy and the behavior of a small open economy."

3) Then there is the further problem of distinguishing between the short- and long-run in applying any theoretical model of exchange rate movements to the US economy. (Actually, this problem exists for all economic theories of a national economy, not just exchange rates . . . unless the modeler pins down persuasively the time-frame that distinguishes the short- mid- and long-term adjustments.)

4) What follows? Well, consider the problems of tracing the impact of a monetary contraction in the US.

(i.) Interest rates, in the very short run, will presumably rise --- at any rate, short-term interest rates will. (The Fed, of course, can't determined long-term rates --- whatever these time-frames mean --- because they are determined by supply and demand in the loanable funds markets.)

(ii.) The impact of higher interest rates in the US? If capital can move freely across borders in the world, then --- if relative real interest rates were higher here now than in the euro-zone and Japan and lots of important developing countries --- capital inflows here would mushroom in the US, and soon (the very short term? the short term?, the mid-term?) there would be upward pressure on the nominal exchange rate of the US$, but downward pressure on interest-rates here.

(iii.) The overall effect of these two different tendencies on GDP growth --- monetary contraction raises interest rates initially in the US, but capital inflows then offset some or all of the interest rate rise and simultaneously raise the exchange rate of the $US --- is obviously a complicated matter. US exports will almost certainly fall off in overall value, with a time-lag of course, but if capital movements are generally free and mobile, the inflow of new capital into the US will offset all or part of the interest-rate impact and very likely keep the US economy growing.

5) Recallthese complications --- the US economy

i) combines the behavior of both a closed and open economy,

ii] is large enough to influence world interest rates (owing to capital movements in and out of the US,

iii]and will behave differently in the very short, short-, mid- and long-terms (all vaguely defined)

And now add to these complications two or three others:

iv) world-wide, capital movements aren't fully free or mobile (think of China, even Japan with its restrictions).

v) expectations of political and economic stability in various countries world-wide will influence the decisions of financial investors --- private and governmental.

vi) these expectation, in turn, are influenced by global political (and possibly ecological) disturbances: wars abroad often lead investment inflows into the safe US, huge ecological disaster in China will influence expectations of investors about the current and future course of Chinese economic modernization . . . with its huge corruption, flimsy safety standards for its urban areas, and its growings needs for diverting large amounts of revenue to these problems of the environment --- natural and urban, bothy influenced mightily by China's rapid industrializing.

6) Add all this up, and obviously we are in the realm of macro-economics, not micro. And whether there is now any reliable model --- even variations of the Mundless/Fleming one (now almost a half-century old, but always adapted by others with changes) --- is another matter.

And hence how capital controls would influence the US economy --- except as likely to be harmful in any long-term sense (say, more than a decade in time) --- is almost entirely a subjective opinion, no?

Not that it will keep modelers from their latest tinkerings that will involve two- or three-step regressions, with enormous new technical stuff that has to be looked up by almost every other person, and with absurd claims about an error-term so small that you need a telescope to bring it into focus.

--Michael Gordon, AKA, the buggy professor:

Scott Shore writes:

For many years I have taught Economics at the undergraduate and graduate level. As a former partner in a corporate strategy firm, I feel intellectually honest teaching Microeconomics and I can relate it to shareholder value and market structure and dynamics. I "know" Macro but I always feels like an intellectual fraud when teaching it. It's not clear that much can be said with any certainty and cause/effect-chicken/egg problems exist everywhere. Unlike Micro, I often feel one could argue strongly for any side of an argument. Basically, I introduce Macro with the idea that-in contrast to Micro- we're dealing with dealing with exponentially greater number of variables, empirically messier evidence and that it teaches the need for humility more than anything else.

In Florida, Macro (not Micro) is required for high school. I personally think that real economic thinking would be advanced by requiring Micro. In any case, how do others deal with this dilemma without undermining the class. I am open to all reasonable suggestion that I can use in the classroom--including supplementary materials, texts or books.
Thank you.
Scott Shore

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