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Exchange Rate Instability.

Exchange Rate Instability

IN HIS PREFACE to Exchange Rate Instability, Richard Layard notes that in 1980 over one million British jobs were lost because of an overvalued pound. The U.S. suffered the same consequence with the overvalued dollar. Devaluation of the dollar often has been recommended to increase the competitiveness of U.S. manufacturing. Firms may long for the stability of the fixed-rate system, but others have argued that purposeful devaluation of the currency yields no long-term competitive benefits.

This dilemma is discussed in Exchange Rate Instability. The book is a set of three lectures that Paul Krugman gave at the London School of Economics. The first lecture proposes a new means of understanding why changes in e xchange rates often are necessary. The second lecture outlines how exchange rates are delinked from reality. Volatile rates render the exchange rate adjustment less effective at balancing the current account, which in turn encourages further volatility. Finally, Krugman reflects on the future of the exchange rate regime.

In "The Case for Exchange Rate Flexibility," Krugman notes that Roland McKinnon, Robert Mundell, and other global monetarists advocate a return to the gold standard and the establishment of purchasing power parity. Their model presupposes a perfectly integrated world economy. While Krugman acknowledges that changes in transportation and communications technologies tend to increase internationalization, political barriers militate against economic integration. Tariffs, quotas, and exchange controls decreased world trade during the war and interwar years. Krugman argues that not enough economic integration has been achieved to change two facts: (1) Citizens of each nation have a much higher marginal propensity to consume the goods they themselves produce than do citizens of other countries; and (2) the prices of each nation's labor and goods are sticky in domestic currency. Thus, imperfect integration of the world economy is both a cause and an effect of the instability of exchange rates.

In making the case for changing the exchange rate, Krugman refutes the position held by the global monetalists who believe that exchange rates should not be set on the criteria of balance of payments adjustments (which they believe should be resolved through fiscal reforms). Krugman notes that the decline of the dollar yields the same result as deflation in the U.S. and inflation abroad. Indeed, the U.S. trade deficit was slow to respond to the dollar's decline in 1985, which the author cites as an example of the imperfect integration of the world economy, a "slippage of gears," Furthermore, currency depreciation solves the problem of coordinating domestic wage cuts.

In Part II, "The Delinking of Exchange Rates From Reality", Krugman proves: (1) that exchange rates can fluctuate so much because they exert such little effect, and (2) that exchange rates exert so little effect because they move so much.

With regard to (1), large exchange rate changes should have an inflationary impact on the depreciating countries and a deflationary effect on the appreciators. In fact, movements of the dollar were not reflected in the rate of inflation; nominal exchange rates and relative unit labor costs moved in tandem. Furthermore, the decline of every currency vis-a-vis the dollar during the years 1980-85 was concomitant with a steady reduction in domestic infltion in Europe and Japan. In practice, firms price to the export market, i.e., they compress their profit margins to minimize the effect of exchange rates on trade flows and aggregate prices. For example, during the period 1985-87, Swedish unit labor costs rose 70 percent (relative to the depreciation of the dollar), while the price of Volvo cars sold in the U.S. rose only 17 percent.

The sluggish adjustment of trade prices and volumes in response to major exchange rates swings is attributed to the sunk cost model. Exporters incur significant losses ("sunk costs") in market entry before realizing a profit. The irreversibility of this investment makes trade unresponsive to the exchange rate. A currency movement of a few points may discourage firms from incurring the costs of market entry, but it will not induce firms already in the market to drop out.

Thus, firms do not have static expectations. Temporary consequences of capital flows or speculative bubbles are viewed as short-term aberrations. The volatility of the exchange markets encourages firms to "wait and see." Exchange rate uncertainty leads to trade inertia. Krugman uses the analogy of the purchase and sale of options for exit and entry decisions. In entering a market, the firm exercises the option to "buy" an expected future stream of earnings at the expense of a current sunk cost. If the exchange rate moves adversely, the expected value of future earnings is lost. If the firm fails to enter the market and the rate becomes favorable, the firm has lost only a fraction of the rise in the expected earnings and holds the opportunity to enter the market at a later date. As extreme exchange rate volatility renders trade flows inert, so does that volatility exert a multiplier effect on delinking the exchange rate from reality.

Finally, Krugman argues that volatility results not only from rational market responses to policy changes but also from failures of international financial markets. Foreign exchange markets fail to recognize short-term trends such that forecast errors are serially correlated. The markets lose sight of the long-term equilibrium and so run with a speculative bubble.

Krugman recommends an eventual return to the adjustable system, setting perhaps a "fat peg" target zone. Changes in West Germany's monetary policy and a correction of the U.S. fiscal deficit would also be required.

This book is worthy reading not only for international economists analyzing forex markets, but also for those with a more general background. The discussion of the impact of exchange rates on the trade deficit and capital outflows should be of interest to everyone. Exchange Rate Instability is highly recommended reading.
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Author:Hill, Donna
Publication:Business Economics
Article Type:Book Review
Date:Oct 1, 1989
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