mechanism is probably about the role of the real exchange rate, the immediate
policy concern is with nominal exchange rates-whether the dollar
should be encouraged, or at least allowed, to decline further, while the yen
rises higher. The idea of promoting exchange rate movements in pursuit of
external balance has come in for extremely sharp criticism from advocates
of a return to some form of fixed rates. For example, Mundell (1987, 3)
writes:
The claim that [favorableconsequences]will follow &om depreciation is sheer
quackery.It is closer to the truth to say that a policy of appreciatingthe yen and
the Europeancurrenciesrelativeto the dollar willcausedeflationabroad,inflation
at home, a larger dollar deficit,and vast equity sales to foreign investors.Ownershipof
factories,technology,and real assets willbe exported to financean even
larger trade deficitwithout there being much,if any, real expansionin exports or
reductionin the dollarvalue of imports.U.S.assetswillbe sold abroad at bargainbasementprices.
If the Americandog gets fed better, it willbe by eating its own tail.
Is this negative assessment at all justified? To make sense of the dispute,
we need to consider two issues. First, the question of whether nominal
exchange rate movements are intended to produce real exchange rate
changes that would not have happened otherwise, or to facilitate real
exchange rate changes driven by other forces. Second, the question of
whether it is indeed easier to adjust relative prices via exchange rate
changes than via inflation and deflation.
The Facilitating Role of Exchange Rate Changes
Suppose that the world economy started from a position of equilibrium and
that a sudden depreciation of the dollar was somehow engineered. Nearly
all economists would agree that in the long run the effect of this depreciation
would be some combination of inflation in the United States and
deflation abroad, with the original real exchange rate being eventually
restored and no long-run effect on external balances. To the extent that
prices and wages adjust slowly, there would be a temporary period of
higher U.s. output and a larger U.S. trade surplus, but few would view this
transitory effect as worth seeking through an exogenous depreciation.
Suppose, however, that the world economy does not start from a position
of equilibrium. In particular, suppose that an adjustment of U.S. and rest-ofworld
fiscal policies requires a real U.S. depreciation against the rest of the
world. Then the situation is very different. If the dollar do~ not depreciate,
there will have to be some mix of deflation in the United States and inflation
abroad. To the extent that prices are slow to adjust, this need to change
internal price levels will lead both to a delay in the adjustment of external
imbalances and a period of unemployment in the United States. An exchange
rate adjustment can facilitate the process of adjustment by eliminating
this need for changes in internal price levels.
The critics of dollar depreciation, such as Mundell, have portrayed the
situation as being our first case, where exchange rate changes are simply
imposed on an equilibrium situation. This view in turn goes back to the
argument that current account adjustment does not require any real exchange
rate changes. However, we have seen that this argument is fallacious.
There is no reasonable quarrel with the view that narrowing current
account divergences requires a fall in the relative prices of goods produced
in deficit countries. A depreciation of the dollar and appreciation of the
currencies of surplus countries looks much more favorable when it is
viewed, not as an attempt to conjure up a real exchange rate change out of
thin air, but as an attempt to achieve more rapidly, and with less cost, a
relative price change that would have happened anyway.
While there may be some in the United States who expected dollar
depreciation to somehow solve the trade problem without any change in
domestic expenditure, the standard view has always been clear on this
point. The underlying problem is to narrow the gap between investment
and savings. However, dollar depreciation is supposed to facilitate the
adjustment of the real exchange rate to its new equilibrium level. To
reject this role for the exchange rate out of hand, on the ground that
exchange rate changes are neutral in the long run, may not be "sheer
quackery," but it is a misrepresentation of a carefully thought-out position.
Now there are some reasonable practical doubts about the current situation:
Has the exchange rate adjustment that has already taken place been
enough? Should exchange rates be encouraged to fall ahead of fiscal policy
instead of waiting for fiscalaction? We turn briefly to these questions in the
last part of the chapter. Meanwhile there is the general question of how
important it is to adjust nominal exchange rates. If it is almost as easy to
change real exchange rates with fixed as with flexible exchange rates, then
one might argue against exchange rate adjustment on ground of monetary
stability even if real exchange rates do need to change.
Read More: The Role of Nominal Exchange Rate Adjustment
