In my latest book titled Other Ways to Implement Fiscal PolicyI have defined two different low interest rate monetary policies, expansionary and contractionary:
Because of the parity nature of interest, we know that both of these are low interest policies. International investors will accept lower interest rates on safe assets in countries where the currency is expected to appreciate over time.
And yet the US example (often called overshooting) is an expansionary monetary policy, leading to a weaker currency over time, while the Swiss example is a contractionary policy, with a stronger franc over time. In retrospect, we cannot infer anything about the state of monetary policy simply by looking at the change in interest rates. Both countries saw lower prices, but one policy shock was expansionary while the other was contractionary.
Interest rates are not monetary policy!
In a recent post, John Cochrane presents an example that is very similar, but with a different framework. His graph shows two scenarios of higher interest rates (expected currencies), but note that he also presents both expansionary and contractionary monetary shocks:
Here is how Cochrane described the graph:
The picture shows the possibilities. Suppose the interest rate increases three times, as shown. What happened to the exchange rate? However, a higher interest rate at t must imply an expected decrease from t to t+1, so there must be three periods of depreciation while the difference persists. The solid red line indicates that possibility. Once the interest rate returns to normal, the exchange rate stops moving, but remains at a permanent low. (The exchange rate is the difference in price levels, so it keeps falling as long as inflation is high.)
But as before, Fisher’s international equation itself is not a perfect model. It does not say what happens to the exchange rate at time t. That level can jump up or down. The dashed lines show three possibilities. The exchange rate may fall and then continue its decline. The exchange rate may jump up, and then the price will go down. Or, the exchange rate may jump high enough that an expected devaluation brings it back to its original level.
We’re back in the selection quagmire of my last post. Standard models now add ingredients to select the equilibrium when the exchange rate returns to its previous level. So, the general answer: Why do higher interest rates increase the exchange rate? However, high interest rates cause a decline. But the exchange rate jumps first and now falls back to its original level.
But why should the exchange rate return to its previous level? That is the Achilles heel of this story. There is no natural force that restores monetary exchange rates. Since the exchange rate is a measure of price levels, we need to think about what the price level anchor is.
Obviously there are a lot of similarities between what John does and what I do. We are both different economists, criticizing the standard model. But there are also important differences. My take is that it’s wrong to talk about monetary policy in terms of interest rates—that doing so is representative lie of reasoning from price changes.
Cochrane believes we need to think about monetary policy in terms of interest rates, because that’s how things work in the real world. But he sees a problem, which he considers a form of indeterminacy, or “multiple-equilibrium”. His search for a solution, a way to put down which method is the true method, led him to the “Price Level Theory of Finance”:
Bottom line: The conventional view of how interest rates affect exchange rates faces many of the same problems as the conventional view of how interest rates affect inflation. For young researchers, this is good news. The most fundamental policy task in international economics is about to be taken. I hope that monetary theory will eventually resolve the multiple-equilibrium gap, and that by treating inflation and exchange rates together as joint policy outcomes we will make significant progress.
I would like to put things down by pointing to a market forecast of NGDP growth, perhaps using futures contracts.
It would be great to have John on the capital market team. He has much better technical and writing skills than I do, and could be the leader of this small school of thought. Unfortunately, he doesn’t like the way to make money. We will have to be content with having a strong partner in our criticism of the standard model, even if he promotes a different model.
Over on my new blog, I have related posts for those who wish to go deeper into the subject.
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