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Is it really the case that countries can’t control their real exchange rate?

Kaveh Pourvand, 6 March 2013

One of the common objections to government attempts to manage the exchange is that the government can only control nominal exchange rates, rather than real exchange rates. The implication is that exchange rate targeting by governments is futile. See for example, Phillip Booth’s cogent critique of the John Mill-authored Civitas publication A Price that Matters. However, this argument is questionable. Before detailing this argument against exchange rate management, it is worthwhile outlining the distinction between nominal and real exchange rates. A nominal exchange rate is simply the numerical value of an exchange rate – what one sees at a Thomas Cook exchange shop. If one pound is worth two dollars, than the nominal sterling-dollar exchange rate is simply $2.

Real exchange rates take into account the purchasing power of each currency, the bang for the buck (to use a dollar-centric term). Possibly the most fun and popular example of a real exchange rate indicator is the Economist’s Big Mac Index. Suppose that a big mac costs $2 in the US and £1 in the UK. Then, if the nominal exchange rate is also £1 to $2, the real exchange rate is still 2. In other words, £1 has the same purchasing power in America (after being converted into dollars) as it does in the UK. The currencies are in a state of what economists call Purchasing Power Parity). However, if we tweak the above example so that a big mac costs £2 in the UK, then in real exchange rate terms, the pound is over-valued compared to the dollar. The £2 that buys one big mac in the UK, will obtain two big macs in America after being converted to $4 at the nominal exchange rate of £1 to $2. The Economist updates its Big Mac Index of real exchange rates every day. Of course, the Big Mac Index is only a very rough measure focusing on one commodity. More accurate and formal measures of the real exchange rate refer to a broad basket of goods.

The above example can also be used to illustrate the argument that governments can only influence the nominal exchange rate rather than the real rate. Suppose again that the nominal exchange rate is £1 to $2 and the real exchange rate is 2, and that instead of big macs, our hypothetical one commodity economies sell widgets. Suppose further that widgets can be imported and exported, and the Americans adopt a competitive exchange rate target to boost their widget exporters at the expense of British widget exporters. An American devaluation may cause the dollar to weaken against sterling so that £1 is worth $4 instead of $2. One might think that this will make US widget exports more attractive to British consumers. Before they obtained one widget for every pound (£1=$2=1 widget) but now they would look forward to getting two widgets for every pound (£1=$4=2 widgets).

However, the devaluation will also eventually cause the US dollar price of widgets to increase by the same proportion as the dollar has weakened against sterling. In other words, following devaluation, a US widget will eventually cost $4 rather than $2 (a 50% weakening of the dollar is matched by a 50% increase in the dollar price of US widgets).  So the real exchange rate is unchanged. One British pound still purchases the same number of American widgets (£1=$4=1 widget). It’s just that now the nominal ratios have changed. In practice, all the Americans would have done with their attempted devaluation is to generate domestic inflation. The real exchange rate, which is what impacts imports and exports, is determined by other factors (chiefly productivity) and beyond the reach of governments.

The argument assumes that the government can only devalue a currency by increasing the money supply – and consequently increasing inflation. In other words, to return to the above example, the US government would have devalued by simply printing more dollars. While increasing the circulation of dollars makes the currency cheaper in relation to sterling, it also increases the price of US goods, creating two countervailing trends that cancel each other out. This assumption is questionable; for two reasons:

First, supposing the government does attempt to devalue the currency by effectively printing more money, it is not certain a priori that the increase in inflation will be commensurate with the devaluation of the exchange rate. The Bank of England has conducted significant quantitative easing (money printing) since the 2008 financial crisis. Between January 2007 and January 2013, the sterling effective exchange rate (the average of sterling exchange values with the currencies of Britain’s major trading partners) fell by almost 23%. However, inflation, as measured by the Consumer Price Index, has only increased by 17.3%.*

Second, there is more than one way to skin a cat. There are ways that the government can reduce the value of sterling without increasing the domestic money supply – for example with capital controls. In the UK, sterling’s value has stayed high relative to other currencies due to the effect of high capital inflows. Referring to IMF figures, John Mills has pointed out that the UK has received over £615bn of net inward investment between 2000 and 2010. If the government restricted these inward flows, by making takeovers of British companies more difficult for example, then this would help lower the value of sterling. Of course, one can argue whether restricting foreign takeovers is a good or bad thing per se. But this is one way the government can impact the exchange rate without increasing the money supply. Brazil for example has very openly imposed capital controls after the 2008 financial crisis to prevent the real from appreciating. Its measures have included a 2% tax on foreign investments in domestic debt and equity, which is collected at the initial level of conversion, in a manner similar to a Tobin tax. Another possibility, that Martin Wolf has highlighted, is for the Bank of England to buy foreign currency directly.

In sum, while the government should be wary of inflation in any devaluation strategy, there are ways it can pursue competitive exchange rate targeting that can impact real exchange rates.

*The exchange rate data is from the Bank of England and was sourced from page 2 of the pdf of this speech by Bank of England economist Martin Weale. CPI data was obtained from the ONS.


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