Scott Sumner  

Never reason from a price change, example #305

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Over at TheMoneyIllusion I have a series of posts exposing the common fallacy of "reasoning from a price change." (Trademark) This occurs when people assume that consumers will buy less oil when the price is high, or there will be less investment when interest rates are high, or there will be fewer exports when exchange rates are high. In fact, the effect of price changes on equilibrium quantities depends entirely on the cause of the price change. When prices rise due to less supply, quantity falls, when they rise due to more demand, quantity rises.

This "Buttonwood" article (in The Economist) is entitled "Here we go again." Exactly:

THE game of "pass the parcel" is enjoying another round. The yen has fallen by nearly 17% against the dollar since Shinzo Abe became prime minister of Japan at the end of December last year. That may be a boost to the competitiveness of Japanese exports but foreign-exchange markets are a zero-sum game: if one currency weakens, another must strengthen.
One can make an argument that currency weakness caused by high saving policies (China, the Nordics, Germany) hurt other economies, although I don't believe it. However currency weakness caused by expansionary monetary policies (Japan) is clearly a win-win when the global economy is depressed. I notice that foreign stock markets go up whenever the Fed tries to depreciate the dollar, and I presume the reverse is also true when the BOJ tries to depreciate the yen.
It is worth remembering that a devaluation is a reduction in a nation's standard of living: it costs more for domestic consumers to buy foreign goods. That is why governments tended to resist them. By the same token, however, a devaluation is akin to a wage cut, a way of making a nation's goods more competitive in global markets. And it is a lot easier than asking workers to accept actual cuts in wages.
There's some truth to the claim that a devaluation is akin to a real wage cut, and just as with wage cuts the impact on living standards depends on why the currency depreciated. If a country suffers currency depreciation due to supply-side problems (bad weather, political turmoil, etc.) then living standards will fall. However if the cause is supply-side problems, then the falling currency is just the messenger. Ditto for real wages. If real wages decline for supply-side reasons then living standards will fall, but the underlying reason is the supply-side problems, real wages are simply a messenger.

On the other hand if a currency depreciates because of an easy money policy that addresses a shortfall in demand, then living standards will rise. The same is true of real wages. When real wages decline due to a boost in AD in a depressed economy, then living standards rise.

The period of March - July 1933 is a perfect example. The US economy was very depressed. The dollar fell very sharply. Real wages fell sharply (when deflated by the WPI.) And living standards rose.

COMMENTS (11 to date)
Jon Murphy writes:

Thank you for posting this. It is a very important lesson. Price and quantity are not the determinants (they are the results): it's supply and demand that are the determinants.

Joe S writes:

Typo: "However if the cause is supply- [demand] side problems..."

Scott Sumner writes:

Thanks Jon.

Joe, I meant supply-side, although I can see why you read it the other way. I meant that when supply side problems cause a currency to depreciate, the supply side problems cause the fall in living standards, and the currency depreciation is just signaling that effect. Indeed it helps prevent an even steeper fall in living standards.

Mark Thomson writes:

I think you need to explain this -

When real wages decline due to a boost in AD in a depressed economy, then living standards rise.

If you mean that these happen simultaneously then for your lay audience you need to explain the distinction between 'real wages' and 'living standards'.

On the other hand if you mean (for example, something like...) "real wages for some people decline and then later on as a result real wages for everyone rise", then I suggest you say so.

Jason S. writes:

Japan's living standards will rise due to easier money, but it's not entirely clear that the policy is win-win for the world. Yen depreciation should, in the short run, hurt exporters to Japan and producers competing with Japanese imports. But I would agree that economic commentators tend to exaggerate the trade effects of monetary policies ("currency wars" and the like), which obtain only in the short run and in any case still account for just a small share of output.

andy writes:

On the other hand if a currency depreciates because of an easy money policy that addresses a shortfall in demand, then living standards will rise

A friend just told me that a recent depreciation caused by the Czech national bank caused an immediate loss of $400.000 in the company she is working in. Considering that most holders of CZK are probably czech people and depreciation is a zero sum game, you would expect the result to be loss to Czech people and gain to strangers. Isn't the question really 'whose living standards' will rise?

Andrew_FL writes:

Makes it kind of funny to speak of the economy being depressed in those circumstances, though, eh?

Scott Sumner writes:

Mark, Living standards depend on real income, which rises as real hourly wages fall. The reason is that more hours are worked.

Jason, The income effect usually dominates the substitution effect. Thus the gain to the rest of the world from a stronger Japanese economy exceeds the losses from more Japanese exports. Indeed the Japanese trade balance may not even rise.

Andy, Was the Czech depreciation caused by easy money, or economic problems in the Czech republic?

andy writes:

The czech depreciation was caused by central bank on purpose (exchange rate intervention). About 2 months ago.

Scott Sumner writes:

Andy, If the Czech economy was depressed then the depreciation should boost output. In that case it's not a zero sum game. More output means the total pie is bigger, meaning the average Czech citizen gets a bigger slice.

andy writes:

More output means the total pie is bigger, meaning the average Czech citizen gets a bigger slice.

Depreciation means income effect means smaller pie. The Czech economy is probably as depressed as pretty much any economy in EU these days (probably even less compared to much of the EU). It's a small open economy. We are 4 years into great recession; do we still have problems with non-flexible prices - which as far as I understand is what depreciation is supposed to fix?

Now there was a 'boost' in GDP december; but we are an open economy - and germany got better at that time too. There was a 'boost' - but do we properly factor in the price of depreciation (I hope I don't remember it incorrectly, but I think 70% of GDP are exports).

How can we factor in the price of the depreciation?

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