Scott Sumner  

Nominal exchange rates, real exchange rates and protectionism

Is America in Retreat?... Both Sides Gain from Exchange...

The three concepts mentioned in the title of the post are completely unrelated to each other. So unrelated that the subjects ought not even be taught in the same course. The nominal exchange rate is a monetary concept. Real exchange rates belong in course on the real side of macro, perhaps including public finance. And protectionism belongs in a (micro) trade course.

The nominal exchange rate is the relative price of two monies. It's determined by the monetary policies of the two countries in question. It plays no role in trade.

Protectionism is a set of policies (such as tariffs and quotas) that drives a wedge between domestic and foreign prices. Protectionist policies reduce both imports and exports. They might also slightly affect the current account balance, but that's a second order effect.

Real exchange rates influence the trade balance. When there is a change in either domestic saving or domestic investment, the real exchange rate must adjust to produce an equivalent change in the current account balance. A policy aimed at a bigger current account surplus is not "protectionist", as it does not generally reduce imports and exports, nor does it drive a wedge between domestic and foreign prices. It affects the gap between imports and exports. Here are some policies that can lead to a lower real exchange rate and a bigger current account surplus:

1. The central bank can accumulate lots of foreign assets, increasing national saving.

2. The government can run a budget surplus.

3. The government can create a sovereign wealth fund.

4. The government can encourage private savings, via a pay as you go retirement system.

[Update: I meant fully funded pension system, not pay as you go.]

5. The government can switch from an income tax to a consumption tax.

None of these are protectionist. A low real exchange rate is sometimes called a "competitive advantage", although the concept has absolutely nothing to do with either competition or advantages. It's simply a reflection of an imbalance between domestic saving and domestic investment. These imbalances also occur within countries, and no one ever worries about regional "deficits". But for some odd reason at the national level they become a cause for concern. Some of this is based on the mercantilist fallacy that exports are good and imports are bad.

Here's David Glasner:

Currency manipulation has become a favorite bugbear of critics of both monetary policy and trade policy. Some claim that countries depress their exchange rates to give their exporters an unfair advantage in foreign markets and to insulate their domestic producers from foreign competition. Others claim that using monetary policy as a way to stimulate aggregate demand is necessarily a form of currency manipulation, because monetary expansion causes the currency whose supply is being expanded to depreciate against other currencies, making monetary expansion, ipso facto, a form of currency manipulation.

As I have already explained in a number of posts (e.g., here, here, and here) a theoretically respectable case can be made for the possibility that currency manipulation can be used as a form of covert protectionism without imposing either tariffs, quotas or obviously protectionist measures to favor the producers of one country against their foreign competitors.

I disagree with this. There is no theoretically respectable case for the argument that currency manipulation can be used as protectionism. But I would go much further; there is no intellectually respectable definition of currency manipulation.

And the most egregious recent example of currency manipulation was undertaken by the Chinese central bank when it effectively pegged the yuan to the dollar at a fixed rate. Keeping its exchange rate fixed against the dollar was precisely the offense that the currency-manipulation police accused the Chinese of committing.
Because currency manipulation does not exist as a coherent concept, I don't see any evidence that the Chinese did it. But if I am wrong and it does exist, then it surely refers to the real exchange rate, not the nominal rate. Thus the fact that the nominal value of the Chinese yuan was pegged for a period of time has no relevance to whether the currency was being "manipulated". The real value of the yuan was appreciating.

The dollar was pegged to gold from 1879 to 1933, and yet I don't think the US government was "manipulating" the exchange rate. And if it was, it was not by fixing the gold price peg, it would have been by depreciating the real value of the dollar via policies that increased national saving, or reduced national investment, in order to run a current account surplus. In my view it is misleading to call policies that promote national saving "currency manipulation", and even more so to put that label on just a subset of pro-saving policies.

If economists want to use the term 'currency manipulation', then they first need to define the term. I have not seen any definitions that make any sense.

Here's China's real exchange rate, which has been appreciating over time.

Screen Shot 2017-06-22 at 12.18.58 PM.png

COMMENTS (13 to date)
John Hall writes:

One quibble: the net trade balance between the U.S. and China increased most strongly in that 2000-2005 period post WTO entrance* when the yuan was fixed against the dollar. The growth in the net trade balance (in absolute terms) has slowed significantly since 2005 when the Chinese government began to allow more flexibility in the yuan, and especially so as the flexibility has increased in recent years.

*Certainly a significant real event that would have increased the deficit regardless. The relevant question though is if the deficit would have increased as significantly had they not had fixed exchange rates.

Cloud writes:

Recently, Joe Gagnon of PIIE has coauthors several research on what policy can affect the current account balance. His finding is that QE doesn't have much effect on CA, but Fiscal policy and central bank / Treasury buying foreign asset can have quite a large effect.

You can check out his work here:

I have an recent interview with him here :

Colin W. writes:

Agree broadly with your points, here, but I would quibble slightly with your assertion that nominal exchange rates have nothing to do with trade. There is quite a bit of debate in the international finance literature about the importance of monetary policy shocks in explaining real exchange rate fluctuations, with most studies assigning some (albeit sometimes minor) role for monetary policy/nominal factors.

That said, I've always been annoyed when I talk about nominal exchange rates and monetary policy and people (including other economists) immediately jump to the effects on trade, rather than on the domestic impact coming from the monetary policy driving the nominal exchange rate movement. To me that's much more important than any effects on the trade balance.

bill writes:

Is #4 correct? I always thought a PAYGO pension system reduced national savings.

B.B. writes:

"The government can encourage private savings, via a pay as you go retirement system."

That seems wrong. A pay-as-you-go system may be good or bad, but the introduction of such a system should reduce private savings. Working individuals have a lower incentive to accumulate wealth if they expect a government check.

Also, China and other countries can manipulate nominal and -- for a while -- real exchange rates if they have capital controls. But I suspect the major way that China ran a trade surplus was by a strategy of using state power to suppress the labor share of national income and the consumption share of GDP. A surplus was a national strategy, even if it was unwise.

Adam Smith was fine for times of peace. But the mercantilists understood that trade policy is not economic policy but foreign and military policy.

Alec Fahrin writes:


I actually believe the trade balance changed the most in absolute terms during the 2005-2013 period when the yuan appreciated rapidly in real terms.


Why is the effect of QE not similar to the effect of the Treasury buying a foreign asset? Neither appears to have a different nominal effect on the exchange rate (that being a nominal depreciation).

B. B.

Why is a surplus supposedly unwise? A surplus simply reflects a difference between domestic saving and domestic investment. Maybe the policies that cause that difference can be unwise, but a surplus or deficit in the current account is not "unwise" or "wise" or anything.

Alec Fahrin writes:


I have a question about exchange rates. I personally believe they are mistakenly misunderstood by many laymen, and purposefully misrepresented by many economists for political reasons.

I have read and heard about three exchange rates. The nominal exchange rate, the real exchange rate, and the trade-weighted exchange rate. The nominal exchange rate is generally all that is discussed in the media. The real exchange rate is sometimes mentioned in economic news. But, the trade-weighted exchange rate is practically never mentioned.

Can changes in the nominal exchange rate indirectly effect the real and trade-weighted rates? In China since August 2015, the falling nominal exchange rate spooked millions of Chinese and businesses even as the real and trade-weighted rate appreciated. This event was followed by $1 trillion in capital outflows.
To me, it appears like the nominal change affected expectations and caused the 2016-present real depreciation in the yuan. If I am not mistaken, do you know why?

Scott Sumner writes:

John, The issue is not the nominal exchange rate, it's the government saving policy. Cloud's comment bears on this point. There are lots of examples of Latin American countries with very weak currencies, which did not run CA surpluses. This is because they had low domestic saving. It was the high rate of government saving in China that caused the big surpluses, and they would have occurred even if the yuan had floated. The eurozone has a bigger surplus than China, and its currency floats.

Cloud, Good point, and see my reply to John.

I've ordered Gagnon's new book.

Colin, I should clarify what I said. Yes, nominal shocks can have real effects in the short run, due to sticky prices. But to the extent that it affects trade, it's because the real exchange rate has changed. Furthermore, much of the concern about CA imbalances reflects long run trends, which cannot be explained by nominal stickiness.

Bill and B.B., Yes, I fixed it. Brain freeze.

B.B. You said:

"But the mercantilists understood . . . "

Don't you mean misunderstood? A CA surplus does not help a country in wartime.

I'm not sure the Chinese had a deliberate policy of large CA surpluses. South Korea ran CA deficits during their high growth years, and did even better than China. And the CA surpluses in China have recently become much smaller. Is that also an intentional strategy? Why?

I suspect the Chinese government has little control over these things.

Alec, A trade weighted exchange rate relates to multiple countries, not one. It can be reported in either nominal or real terms. So there are actually four options; real and nominal bilateral exchange rates, and real and nominal trade weighted exchange rates.

Philo writes:

@ Scott:

I see that the nominal exchange rate, Euro/USDollar, is 1 Euro = 1.12 USD. I have a question (of the sort you will inevitably get from non-economists): What is the real exchange rate? (And how did you arrive at your answer?)

Your post seems to say that a nation's current-account balance cannot change without a change in the real exchange rate of its currency. I do not at all understand that (if it is really your view). How could that apply between nations that used the same currency--for example, nations that belonged to the Euro zone--or between states of the United States? (Of course, no one bothers about the current-account balance of a state, but I believe the concept makes perfect sense.)

Scott Sumner writes:

Philo, Good question. My point was not that a CA balance cannot change without a change in the exchange rate, but rather a government policy that aims for a bigger CA surplus works through changes in the exchange rate, and specifically the real exchange rate.

Here's an analogy. It's perfectly possible for oil consumption to increase without any change in oil prices, if both S and D shift to the right. But if Saudi Arabia decided to try to boost global oil consumption, it would do so by increasing the supply of oil, and this action would cause more oil consumption by the mechanism of reducing the price of oil. And what matters is the real price of oil, not the nominal price.

The real exchange rate is the relative cost of living in two countries. If PPP holds, the real exchange rate is 1.0.

If the cost of living in Switzerland is 25% above the US COL, then the real exchange rate of the Swiss franc is 1.25.

Countries with high inflation often see a big fall in their nominal exchange rate. But that does not help their exporters as the advantage is offset by higher costs from the inflation, leaving the real exchange rate unaffected.

Patrick Barron writes:

There is nothing that any country can do to force another, against its will, to subsidize its economy in any way. Currency debasement, usually intended to increase exports, is a gift to the importers and fully paid by the citizens of the exporting country. Protectionism merely means that a government prohibits its own citizens from enjoying the fruits of the labors of people who just happen to reside in another country. I could go on, but you get the idea.

Margaret writes:

Trying to get a handle on these concepts. I always thought interest rates affected the value of the currency and thus the ability to attract foreign investors but disability to sell domestic goods abroad. If foreigners can earn a higher return here they will invest here, but they will be less likely to buy our goods because they have to pay too much of their currency for our dollar.

I think that back in 1902 Hobson more or less articulated the problem the West faces with regard to China and the other Asian Tigers today:

It is here enough to repeat that Free Trade can nowise guarantee the maintenance of industry, or of an industrial population upon any particular country, and there is no consideration, theoretic or practical, to prevent British capital from transferring itself to China, provided it can find there a cheaper or more efficient supply of labour, or even to prevent Chinese capital with Chinese labour from ousting British produce in neutral markets of the world. What applies to Great Britain applies equally to the other industrial nations which have driven their economic suckers into China. It is at least conceivable that China might so turn the tables upon the Western industrial nations, and, either by adopting their capital and organisers or, as is more probable, by substituting her own, might flood their markets with her cheaper manufactures, and refusing their imports in exchange might take her payment in liens upon their capital, reversing the earlier process of investment until she gradually obtained financial control over her quondam patrons and civilisers [emphasis added]. This is no idle speculation. If China in very truth possesses those industrial and business capacities with which she is commonly accredited, and the Western Powers are able to have their will in developing her upon Western lines, it seems extremely likely that this reaction will result.

--John Atkinson Hobson , Imperialism: A Study , 1902 (pp. 329-30).

The text here was copied from Google Books which doesn’t have page numbers. The page numbers are from:

[Quote is from paragraph II.V.35. Hobson's book, Imperialism, is available online on Econlib.--Econlib Ed.]

Comments for this entry have been closed
Return to top