Who Controls the Exchange Rate?

The Reserve Bank says its influence is overrated.

Listener 26 February 1994 This is the third of a sequence of four columns written in the early 1990s about monetary policy, which continue to be significant today. They are
The Hole in the Reserve Bank
What the Reserve Bank Believes
Who Controls the Exchange Rate?
The Meaning of Influence

Keywords Macroeconomics & Money

In my last column I remarked that the Reserve Bank sometimes makes confusing and contradictory statements. In this I want to give an example.

Just over a year ago the Bank’s Governor gave a speech to the Auckland Manufacturers, Association, subsequently published in the Reserve Bank Bulletin. It made six points. Here we look at three, the remainder being less contentious.

Point five was that monetary policy cannot “sustainably influence” the real exchange rate (the relativity between domestic and international prices). The paper does not argue the point of the lack of Reserve Bank influence. It merely states it with an unconvincing illustration, as if that were sufficient to make it true. Perhaps manufacturers dont need explanations.

But they must have been puzzled when they recalled point three: “It is indeed quite likely that, in the long term, there will be a tendency for the New Zealand dollar to appreciate against the currencies of our trading partners to the extent that inflation in New Zealand runs at a rate below that of our trading partners.” In effect, the Governor was saying, the real exchange rate will be constant in the long run. When our inflation is lower, which would improve the real exchange rate, the nominal exchange rate will appreciate, cancelling the gain.

Now the Reserve Bank controls two of the three components which make up the real exchange rate. Its objective – in statute and by government direction – is to control the domestic price level. Increasingly it is admitting to targetting on the nominal exchange rate (the price of the New Zealand dollar compared with other currencies), as a main means of controlling the price level. Only the world price level is outside the Reserve Bank’s control.
So although reluctant to admit it, the Bank is controlling the real exchange rate in the short run, which seems to make a mockery of the sixth point: “the Reserve Bank cannot engineer a sustainable improvement in the economy’s competitiveness, collectively you [the audience of manufacturers] can.” Indeed the speech’s message is that if exporters collectively improved their competitiveness by keeping prices down, the Bank would engineer an offsetting nominal exchange rate appreciation.

There are various ways to get out of this muddle, but there is little guidance from the Reserve Bank’s writings, even interpreting their ambiguity as generously as possible. For instance if exporters determine competitiveness in the long run, they must also be determining the nation’s long run price level. In which case the Bank cannot be controlling the long run price level, nor the rate of inflation. If true, what we are seeing from the Bank is short term posturing and bullying. I doubt it would agree to this resolution of the confusion. But the alternatives involve using economic terms in creative ways, or confusing levels and changes (analogous to distances and speed), something which the Bank’s writings do far too frequently.

Part of the trouble arises because the Reserve Bank Act has no underpinning theory. There is Milton Friedman’s slogan all “inflation is always and everywhere a monetary phenomenon”. However in a recent book the master seems to have backed down from its universal application writing (using the italics of the original) “substantial inflation is always and everywhere a monetary phenomenon“. Statements about “substantial” inflation tell us nothing about our current low levels of inflation.

Is the more general slogan true? The theories that purport to demonstrate its veracity are not very compelling, and their empirical support usually assumes the truth rather than investigates it. More seriously for our case, they describe closed economies, not those open to the outside world with exports, imports, and capital flows.

Even were we able to prove the truth of the slogan, yet another step is necessary to get to the Reserve Bank’s conclusion. Perhaps monetary phenomena also affect the real economy: investment, exports, production, employment. The usual explanations use a neat mathematical twist to deny the possibility, but the real world is not always so kind.

In any case, the theories assume that the path to the long run does not affect the ultimate outcome. But the Reserve Bank’s own econometric model demonstrates path dependent effects, where the final state of the economy is consequential on the route taken over time. Which is not surprising. A monetary squeeze may mean less investment in physical capital, in human capital (i.e. education and training), in research and development, and in international market development. One would expect output to be lower in the long run. The monetarist models overlook this because they usually assume a static economy, which leave these elements out of their analysis. It is perhaps not surprising that their policies seem to generate stagnation.

By locking us into a particular level of competitiveness, the Reserve Bank threatens slow growth (business cycle upswings aside). If international competitiveness is too low, the export sector’s development is inhibited, as are import substituters. The smaller tradeable sector would mean smaller output, less investment, and more unemployment.

It is no good the Reserve Bank just denying all this with another public relations handout. As a first step to really defend their position the Bank needs to offer an explanation of the determinants of the economy’s competitiveness, which are independent of monetary policy. They will find no such conclusion in their own econometric model.

Suppose the Bank made no more pronouncements until it has plausibly demonstrated money has no long run influence on the real economy. We would be in for a long period of silence.