My recent book “ Alternative approaches to monetary policyI have discussed two different types of low-interest monetary policy: expansionary and contractionary.
The interest rate parity condition tells us that both of these are low interest rate policies. Foreign investors will accept lower interest rates on safe-haven assets in countries where the currency is expected to appreciate over time.
Nevertheless, the US example (often referred to as overshooting) is an expansionary monetary policy that leads to a weaker currency in the long run, while the Swiss example is a contractionary policy that leads to a stronger franc in the long run. . Conversely, we cannot infer anything about the stance of monetary policy by looking only at changes in interest rates. Nominal interest rates fell in both countries, but one policy shock was expansionary and the other was contractionary.
Interest rates are not monetary policy!
In recent posts, John Cochran shows a very similar example, but with a different framework. Note that while his graph shows two cases of interest rate increases (where currency appreciation is expected), it also shows both expansionary and contractionary financial shocks.
Cochrane explains this graph:
The photo shows the possibilities. Assume that interest rates rise over three periods, as shown in the figure. What will happen to the exchange rate?Well, a higher interest rate at t should mean that depreciation is expected from t to t+1. Therefore, there must be three depreciation periods during the duration of the interest rate differential. The solid red line indicates that possibility. Once interest rates return to normal, the exchange rate will stop moving, but at a permanently lower level. (The exchange rate is the difference in price levels, so as long as the inflation rate is high, the exchange rate will continue to fall.)
However, as before, the international Fisher equation itself is not a complete model. There is no mention of what the exchange rate will be at time t. That percentage can jump up or down. The dashed lines indicate three possibilities. Exchange rates have fallen sharply and are likely to continue falling. Exchange rates can rise significantly and then fall. Alternatively, the exchange rate may appreciate enough that the expected depreciation will bring it back to its original level.
We are back to the quagmire of equilibrium selection from the previous post. In the standard model, material is now added to select an equilibrium in which the exchange rate returns to its previous level. So the standard answer is: Why do exchange rates rise when interest rates rise?Well, when interest rates rise, asset values fall. However, the exchange rate may first rise sharply and then fall back to the yuan level.
But why should the exchange rate return to its previous level? That is the Achilles heel of this story. There are no natural forces that can reverse the nominal exchange rate. Since the exchange rate is a ratio of the price level, we need to consider what the nominal anchor of the price level is.
Obviously, there are a lot of similarities between what John is doing and what I’m doing. We are both maverick economists and critical of the standard model. But there are also important differences. My conclusion is that talking about monetary policy in terms of interest rates is simply wrong. fallacy of make inferences from price changes.
Cochrane believes that monetary policy needs to be thought of in terms of interest rates. Because that’s how the real world works. However, he regards this problem as a type of uncertainty, or “multiple equilibrium” problem. Searching for a solution, a way to identify which path is the real path, he arrived at the “price-level financial theory.”
Conclusion: The standard view of how interest rates affect exchange rates suffers from many of the same problems as the standard view of how interest rates affect inflation. For young researchers, this is great news. The most basic policy exercise in international economics is now being challenged. I hope that significant progress will be made in fiscal theory finally solving the gaping hole of multiple equilibria and treating inflation and exchange rates together as joint outcomes of policy.
I would like to target market predictions of NGDP growth, perhaps using futures contracts, to get things right.
John would be a good addition to the Market Monetarist team. He has much better technical and writing skills than I do, and will soon become the leader of this small school of thought. Unfortunately, he is a bit allergic to the monetarist approach. Even if he promotes another alternative model, he will have to be satisfied that he has a strong ally in his critique of the standard model.
In my new blog, Related articles For those who want to dig deeper into the topic.
