Monday, May 11, 2015

Exchange rates and monetary policy

I think one of the more practical things to come out of the information equilibrium model is the description of exchange rates. It is an incredibly simple model that effectively says that exchange rates have little to do with inflation or monetary policy, but are rather about aggregate demand in the two countries you are comparing. If my country's economy is booming and yours is flagging relative to long term trends, your currency is going to be cheap for me.

In the macro world, the fact that the US economy is doing better than Japan or the EU since the 2008 financial crisis means that both currencies are going to look depreciated. The QE undertaken by each country is going to be irrelevant except in the sense that it affects NGDP ... which it doesn't.

Scott Sumner disagrees:
You thought Japanese QE depreciated the yen?  That’s just your imagination.  You think QE recently caused the euro to depreciate?  You are hallucinating.  The dollar fell 6 cents on the day QE1 was announced, in March 2009?  That’s a coincidence.
It is your imagination -- or at least an interpretation of data based on a specific model. And the dollar falling is a market failure, not a coincidence.

The trend in exchange rates follows the relative trends in NGDP:


Today the Yen is 20% below the Dollar, the Euro is 10% below the Dollar and the Euro is almost 20% above the Yen compared to 2009.

Today Japan's NGDP is a little over 15% below US NGDP, EU NGDP is 10% below US NGDP and EU NGDP is about 10% above Japan's NGDP compared to 2009.

... basically in line with the simple information equilibrium exchange rate model.

[NGDP data from FRED and exchange rate data from Bloomberg]
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5 comments:

  1. AnonymousJune 11, 2015 at 3:43 PM

    Hi Jason

    Very interesting can you do it with UK please

    Thanks

    ReplyDelete
  2. AnonymousJune 11, 2015 at 4:09 PM

    Bloomberg says the EUR /GBP over the last 5 years was - 0.11%

    http://www.bloomberg.com/quote/EURGBP:CUR


    So would you expect when you compare the EUR/GB GDP it is around -0.11% over the same time period ?

    Thanks

    ReplyDelete
    Replies
    1. Jason SmithJune 11, 2015 at 6:19 PM

      Hello,

      I did the comparison and the results are interesting, but the recent fall seems to be a result of markets over-reacting to the UK's QE back in 2009 and a slow drift back to "normal" values:

      http://informationtransfereconomics.blogspot.com/2015/06/exchange-rates-and-irrational-markets.html

      Delete
  3. MJune 28, 2016 at 2:23 PM

    Seems a bit counterintuitive. Lower (relative) NGDP means lower (relative) aggregate demand. Lower aggregate demand means lower inflation. Shouldn't lower inflation lead to a strengthening of the local currency?

    Have you looked at the data for Japan over a longer time period? FRED has the exchange rate and nominal GDP figures as far as 1994, and the correlation between the two ratios seems insignificant over the prriod.

    ReplyDelete
    Replies
    1. Jason SmithJuly 8, 2016 at 9:08 AM

      Short run fluctuations do seem to follow the intuition, and the NGDP metric works best when inflation is low (which is also where this model is counterintuitive). More details were linked above ... Here is the relevant link:

      http://informationtransfereconomics.blogspot.com/2014/09/what-do-exchange-rates-measure.html

      Delete

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