The Exchange Rate (index)

Keywords: Macroeconomics & Money;

A correspondent, R.B. Chrystal, to The Listener asked

Why do we have a floating currency and what advantage is it to the country in general? To me it seems that all it does is allow another tier of parasites, ie currency speculators, into the system as well as create more uncertainty for our exporters. The strength or weakness of our dollar seems to bear very little relationship to the strength or weakness of our economy, as was touted when it was floated.

My answer, published in The Listener of 1 August 2003 is given below. Go to Brian Easton’s response I asked another economist to look at my reply. He thought it fine but also offered his account, which does not address the respondent’s question directly, but gives greater insight into official thinking. Go to another economist’s response < Also published here is an extract from In Stormy Seas which offers a definition of the Exchange Rate. Go to Definition

Other website indexes concerned with elements of the exchange rate are:
Reserve Bank of New Zealand and related issues which contains articles in the section on Monetary Policy describing how monetary policy impacts on the exchange rate, and articles in the section on Monetary Union which explores what happens when there is a fixed exchange rate with another economy, and
New Zealand’s Economic Performance which contains articles describing how the exchange rate impacts on the economy.


Defining the Exchange Rate
The following is adapted from In Stormy Seas pages 85-88.

The nominal exchange rate is defined as the number of units of currency that could be bought for one New Zealand dollar. For instance on the day I first wrote this the ruling US dollar exchange rates the previous day was .5477. That means that one New Zealand dollar was trading for 54.77 US cents. The convention means that in a devaluation or depreciation the nominal exchange rate goes down; in a revaluation or appreciation the nominal exchange rate goes up.

In order to define the real exchange rate it is necessary to look at a three sector economy of exportables and importables [which combine into the tradeable sector, and non-tradeables.

Consider a business in the tradeable sector. Its profitability will be dependent upon the price of tradeables, less the costs of its inputs which will be non-tradeables (if we net out tradeable costs from the output price). Thus its performance will depend on the relative price of non-tradeables to tradeables. This ratio is called the real exchange rate. Its index is defined as

The real exchange rate = (the price of non-tradeables)/ the price of tradeables

The definition has a number of implications. First the higher the real exchange rate index the less favourable it is for the tradeable sector, since it is paying higher costs for its inputs. Which is the ratio’s numerator and which is its denominator is a convention.

In this exchange rate convention higher means worse for a producer of tradeable products. A higher nominal exchange rate means fewer New Zealand dollars for each unit of overseas currency they earn. Alternatively a higher real exchange rate means worse for the tradeable sector since their inputs cost more in foreign currency terms.

Second we can change the price of non-tradeables, which are sold only in the domestic market, relative to the price of tradeables which is set in the foreign market, by changing the nominal exchange rate. Suppose the nominal exchange rate depreciates, then the price of tradeables (such as exports) go up (the foreign exchange they earn is more valuable) and the real exchange rate goes down. (So the nominal and real exchange rates tend to move together.) The nominal exchange rate is not the only determinant of the real exchange rate, but it is a very important one.

A small economy has no influence over the foreign currency price it pays for its imports or receives for its exports. Thus its ability to influence its real exchange rate depends on its ability to influence its local price of non-tradeables and its nominal exchange rate. Moreover a change in the nominal exchange rate affects the real exchange rate by the same proportion, if the other prices do not change. In effect the real exchange rate adjusts the nominal exchange rate for differences between local and foreign prices.

In the short run, when domestic prices are not changing much, the real and nominal exchange rates follow similar patterns. In the long run it is better to fouc on the real exchange rate. which is not obscured by domestic inflation.

Interestingly, but perhaps not surprisingly, the pattern of the real exchange rate (REX) roughly – but not perfectly – corresponds with our overall economic performance:
– In the late 1920s the REX rises as the economy plunges in to depression;
– From the mid 1930s through the 1940s the REX drops steeply as the economy expands rapidly;
– In the 1950s through to the early 1970s the REX climbs steadily while our economic performance is disappointing;
– In the second half of the 1970s and the first half of the 1980s the REX is roughly flat: the economy experiences its best post 1950 performance;
– After 1985 the REX climbs very steeply: the economic performance is disastrous.

Here we have then an explanation for the growth performance of the economy. As a rule a low and/or falling real exchange rate is beneficial to the economy, and a high and/or rising one is detrimental.

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Brian Easton’s Answer

Our economics columnist, Brian Easton began by citing Alfred Marshall’s ‘All short statements in economics are wrong, with the possible exception of this one’, and then answered (briefly):

The New Zealand dollar has to float because the other of the world’s currencies are floating. Even had it a fixed link with another currency (say the Australian dollar) that currency floats too, so exporters would still have to cope with currency fluctuations for (at least) 80 percent of other markets. It is unfortunate that business commentators focus on the New Zealand to US dollar exchange rate and tend to neglect other currencies such as the Australian dollar, Euro, Sterling, and Yen. Sometimes the New Zealand dollar goes up relative to the US dollar and down relative to them, to the extent that on average (measured by the ‘Trade Weighted Exchange Rate Index’ – TWI) it falls.

A fixed exchange rate does not avoid currency speculation. Readers will recall that some ‘speculators’ made a killing when the New Zealand dollar was devalued in July 1984. (The currency float was instigated in March 1985.) The difference is that under a fixed exchange rate it is the government which pays the speculators’ profits: Under a floating one their profits come from other private ‘speculators’ who bet the wrong way.

Mr Chrystal is correct that while the rhetoric connects a strong currency with a strong economy, that relationship need not be true. The foreign exchange rate is but a (relative) price, reconciling the demand and supply for New Zealand currency. It is interesting, isnt it, that we get upset if the price of consumer goods rises, but there is cheering by business commentators if foreign currency rate goes up? Those who dont cheer are the exporters, because a high New Zealand dollar means that they get less New Zealand currency for their exports.

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Alternative Response Suggested by Another Economist

The theory that lead us and many others into floating exchange rates said that we would absorb changes in trading conditions more easily. If people stop buying wool carpets in favour of synthetics, or if the UK drops us to fit in with EC policies, we have to change. Unfortunately, change hurts, particularly so for those directly affected. An exchange rate that falls when bad circumstances happen spreads that change through time and across people. A lower dollar would provide some compensation for lower wool and meat prices. A lower dollar would boost returns to other exporters, helping encourage a shift from farming to whatever is more profitable. And a lower dollar would raise prices of imported products to you and I, motivating us to buy more NZ product, and again helping people shift to new businesses.

That was the theory. It kind of works. But exchange rates bounce around a lot more than is needed to absorb changes in circumstances, and often for reasons completely divorced from changes in fundamental trading patterns and prices.

Should we go back and try to fix exchange rates, or is rough and ready still better?

Fixed exchange rates of the type we used to have are these days probably unattainable. We’ve seen countries all over the world forced to give up their fixed rates in crises, having spent billions of taxpayers’ money trying to hold the tide back. That’s not smart.

But completely fixed rates can be had by adopting someone else’s currency, as much of Europe has recently done. For NZ, that would only be partial, and possibly come at a cost. Partial because our biggest trade partner – Australia – only accounts for 20% of our trade. We would still float against 80%. Possibly at a cost, because the 80% still facing floating exchange rates would be facing the Australian dollar. That theory, which kind of works, says the currency should move to absorb shocks. Well, it would be moving to absorb Australian shocks, not New Zealand shocks, and there may be times when those are quite different!

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