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Exchange rates in the USA, Japan, Europe (euro), and China.

My fellow colleagues in the Economics ministries of Japan, Europe, and China, I am here today to present the case as to the best exchange rate policy which I believe is not only beneficial to the USA, but also beneficial to your economies as a whole. 

I will talk about the reasons as to using this type of exchange rates, and also I will talk about the best exchange rate policy, which we have carried out an extensive research, which we believe each country here should adopt to the benefit of the global economy.  I will also briefly talk about how the various exchange rates in your countries would systematically work together with regard to its effects on firms, and households.

Before I start, I would like to identify and talk about the four types of exchange rates that are available to us.  They are:

1. The flexible or floating exchange rate regime: which is when there is no official intervention by the monetary authorities or your government.  The exchange rate here is determined by the equality between the supply and demand for the US dollars arising from the capital and current accounts.
2. Fixed or pegged exchange rate: which is when official intervention is used to maintain the exchange rate at (or close to) a particular value.
3. Adjustable peg: this is where the government sets and attempts to maintain par values for their exchange rates, but explicitly recognize that circumstances may arise in which they will change the par value.
4. Managed float: here the government seeks to have some stabilizing influence on the float, they seek to have some stabilizing influence on the exchange rate but do not try to fix it at some publicly announced par value.

With these four types of exchange rates in mind, we will now move on to talk about the best exchange rate policy I believe the USA should adopt.

A flexible or floating exchange rate which is determined by free market forces of demand and supply is the case I put forward to you.

FLEXIBLE OR FLOATING EXCHANGE RATES

Figure 1: The market for foreign exchange

Using the diagram above, suppose that the current price of the dollar is so low (say, at E1 in figure 1) that the quantity of dollars demanded exceeds the quantity supplied.  Dollars will be in scarce supply in the foreign exchange market; some people who require dollars to make payments to the United States will be unable to obtain them; and the price of the dollar will be bid up.  The value of the dollar vis-à-vis the Japanese Yen will appreciate.  As the price of the dollar rises, the Yen price of US exports to the Japan rises and the quantity of dollars demanded to buy US goods decreases.  At the same time as the dollar price of imports from the Japanese falls, a larger quantity will be purchased and the quantity of dollars supplied will rise.
Thus, a rise in the price of the dollar reduces the quantity demanded and increases the quantity supplied.  Where the two curves intersect, quantity demanded equals quantity supplied and the exchange rate is in equilibrium.

What happens when the price of the dollar is above its equilibrium value?  The quantity of dollars demanded will be less than the quantity supplied.  With dollars in excess supply, some people who wish to convert dollars into Yen will be unable to do so. (Equivalently, we could say that there is an excess demand for the Japanese Yen).  The price of the Yen will fall, fewer yen will be supplied, more will be demanded, and equilibrium will be re-established.

In a floating exchange rate regime, it is exchange rate adjustment that determines the actual current and capital account transactions, even though planned, or desired, trade and investment decisions may have been inconsistent.  Imagine, that at the beginning of some period importers and exporters had plans that would have created a current account deficit and domestic investors had plans to buy international securities (while international traders or investors had no such plans).  The attempt to implement these plans would create a massive excess supply of yen (demand for dollars).  This would force a yen depreciation, which would continue until it moved far enough to force changes in plans.  Indeed, it would depreciate just far enough so that any supply of pounds generated by a current account deficit was just balanced by a capital inflow (or any current account surplus was just balanced by a capital outflow).

FLOATING EXCHANGE RATE UNDER A MONETARY AND FISCAL POLICY

An expansionary monetary policy (a decrease in interest rates) creates an inflationary boom in real activity in the short-run; in the long run the price levels rises in proportion to the money stock increase, and the nominal exchange rate depreciates in the same proportion.  A fiscal policy expansion (an increase in government spending) under floating exchange rates creates little or no increase in real GDP if the money stock is held fixed, even in the short-run.  In the long run there is a sustained real and nominal exchange rate appreciation, and the government budget deficit is matched by a trade deficit and capital account surplus.  In contrast, if the monetary authorities maintain a fixed interest rate, and therefore increase the money stock to accompany the fiscal policy expansion, there will be a short-term stimulus to real GDP.  In the long run the price level will rise and net exports will be crowded out, via a real exchange rate rise as stated before.

Under floating exchange rates with perfect capital mobility, monetary policy is able to stimulate real activity in the short-run.  It does so largely because an expansionary monetary policy depreciates the real exchange rate, which stimulates net exports.  With mobile capital and a fixed money supply, however, the expansionary fiscal policy creates a currency appreciation, which neutralizes the stimulation to real activity.  A fiscal stimulus would give a temporary boost to the real economy where the monetary authorities peg the interest rate, and thus would create an accomodatory rise in the money stock.  The long-run effect of a fiscal expansion with no capital flows is to crowd out investment.  But with mobile capital a fiscal expansion crowds out net exports via an appreciation of the real exchange rate.

MONETARY AND FISCAL POLICY EFFECTS ON INDIVIDUALS AND FIRMS

Individuals:  There are three direct effects.  Firstly, they face new rates of interest on their savings and debts.  So the disposable incomes of savers and borrowers alter, as does the incentive to save rather than consume now.  Second, the value of individual’s financial wealth changes as a result of changes in asset prices.  Thirdly, any exchange rate adjustment changes the relative prices of goods and services priced in domestic and foreign currency.  Of these three effects, the one felt most acutely and directly by a significant number of individuals is that working through the interest rate charged on personal debt, especially mortgages, and the interest rate paid on their savings.  A rise in the official interest rate, other things (notably expectations and confidence) being equal, leads to a reduction in spending by consumers overall and, via an exchange rate rise, to a shift of spending away from home-produced towards foreign-produced goods and services and vice versa.  The size and even the direction of these effects could be altered by changes in expectations and confidence brought about by a policy change, and these influences vary with particular circumstances.

Firms:  An increase in the official interest rate will have a direct effect on all firms that rely on bank borrowing or on loans of any kind linked to short-term money-market interest rates.  A rise in interest rates increases borrowing costs (and vice-versa for a fall).  The rise in interest costs reduces the profits of such firms and increases the return that firms will require from new investment projects, making it less likely that they will start them.  Interest costs affect the cost of holding inventories, which are often financed by bank loans.  Higher interest costs also make it less likely that the affected firms will hire more staff, and more likely that they will reduce employment or hours worked.  In contrast, when interest rates are falling, it is cheaper for firms to finance investment in new plant and equipment, and more likely that they will expand their labour force.  Cash-rich firms will receive a higher income from funds deposited with banks or placed in the money markets, thus improving their cash flow.  This improved cash flow could help them to invest in more capacity or increase employment, but it is also possible that it will encourage them to shift resources into financial assets, or to pay higher dividends to shareholders.  Additionally, policy changes also alter expectations about future course of the economy and the confidence with which those expectations are held, thereby affecting investment spending.

PROPOSED EXCHANGE RATES THAT THE PARTICIPANTS FROM JAPAN, EUROPE, AND CHINA SHOULD ADOPT

Japan:  We do understand that Japan has an adjustable peg exchange rate, in which we believe that this is the most desirable type of exchange rate policy the Japanese should adopt.  Reasons being that it has a zero interest rate policy.  It also has the world’s largest foreign exchange reserves.  Thereby, if the Japanese changed their exchange rate policy otherwise (e.g. to a floating exchange rate), it could lead to an increase in the value of the Yen, in which Japanese exports would become expensive for other countries, and this would hinder the Japanese economy as already seen in recent times.

China: Currently, China has a Fixed exchange rate policy vis-à-vis to the other world currencies.  This has been the case since the mid 1990’s, a policy that we believe is giving Chinese exporters an unfair advantage.  We do understand that the Chinese have held discussions with the International Finance Corporation, an arm of the World Bank, and Asian Development Bank, about renminbi bonds.  They have embarked upon a gradual easing of the amount the renminbi that can be exchanged under capital account, thus eventually leading to full convertibility of the currency to a more floating exchange rate.   They are looking at five measures, which they believe would lead to full convertibility.  They are; Insurance companies to invest overseas, easing foreign direct investment by local enterprises and approving renminbi denominated bond issuance by ‘foreign development organisations’.  This is good news and we believe this would stabilize the imbalance of world trade to the benefit of the Chinese economy and the rest of the world.

Europe:  has a floating exchange rate in which the various members of the Euro (15 members, who have a pegged exchange rate (boundary) to the euro).  This has initially had the effect of causing huge fluctuations with regard to the purchasing power parity within Europe and the rest of the world.  With regard to the US, we believe that a floating exchange rate is the right policy to adopt, however, certain countries within the European union, are prone to severe economic recession if their economies cant keep within the exchange rate band which the European Central Bank sets.  This could lead to huge differences in economic growth within the various members, thereby, it could potentially affect world markets in relation to exports from these countries and imports to these countries (e.g. Romania, Greece, Latvia, and Slovakia are all new entrants of the Euro with economies that are not as buoyant as the core members of Germany, France, Italy, The Netherlands, Portugal and so on).  It would be more productive if each member country of the euro acted as an individual entity rather than as a union.  This would be much better for the world economy as a whole and allow the forces of demand and supply to regulate the various exchange rates within various member countries.

In more recent times, if one measures the US, which holds the key to global financial stability, against the template mentioned above, warning lights immediately flash.  The US economy does indeed suffer from big imbalances, mainly because the authorities i.e. the federal reserve, has delivered freakishly, low interest rates to stave off economic stagnation after the bursting of extraordinary equity market bubble.  The huge US Fiscal and current accounts deficits have not been difficult to finance, because there is a surplus of global savings over investment and a reliance on Asian markets, notably, Japan, and China to finance the budget deficit.  Yet there must be a risk that the US’s financing needs will at some point outstrip the willingness of the handful of key countries to continue investing their official reserves in dollars.  The rise in interest rates that might be required to tempt private capital to finance the deficit could lead to a market crunch, this leads to ask whether Asian central bank financing of the current account deficit will prove to be a ‘fatal embrace’.

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