Thursday, September 11, 2008

Weaker Currency To Lower Inflation?

Today in Swedish media, several economists are interviewed about the dollar rally. I'll return later for other aspects of this issue, but for now I will focus on the incredible claim in the article (it is unclear whether one of the economists claimed this or if this was something the reporter made up) that the stronger dollar will lower Swedish inflation.

Since relative exchange rate strength is a zero sum game, a stronger dollar will mean that other currencies, including the Swedish krona will be weaker. A weaker currency will all other things being equal raise the domestic price inflation rate for 3 reasons: 1) because of the direct impact of higher import prices. 2) because of how the higher import prices will lessen the pressure on domestic producers not to raise their prices 3) because higher export prices will similarly lessen the pressure on domestic producers not to raise prices since they will now be able to sell their products abroad if domestic customers don't agree to the price increases, thus strengthening their bargaining power.

"But", the article says, the stronger dollar will push down oil- and commodity prices and thus reduce that price pressure. Actually though, at least in the long run, a stronger dollar will only reduce the dollar price of commodities. It will by contrast raise the price of commodities in terms of the euro or the Swedish krona. While market irrationality can sometimes make the article's claim true in the short term, this will not be sustainable as the too low price will create excess demand and push down inventories to too low levels and push up the price to goods market equilibrium.

While it is true that the oil price has fallen even in terms of the Swedish krona and while probably not all of that decline is attributable to market irrationality, but to another factor, weakening global demand, that is unrelated to the causal effect of the exchange rate movement alone, which will clearly be to raise the oil price in terms of the Swedish krona, which in turn will raise inflation compared to what it otherwise would have been (that doesn't higher inflation compared to now, it could also mean a smaller decline in inflation than otherwise).

Thus, while it is true that a weaker currency will help exporters it will certainly not lower price inflation.


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