Friday, November 01, 2013

Exchange Rates Are A Zero Sum Game

According to preliminary estimates, euro area inflation fell to 0.7% in October, the lowest since 2009, and "core" inflation fell to 0.8%, the lowest ever during the existence of the euro area.

This has the usual suspects up in arms about "deflationary trap", which is then used to argue that the ECB should try to push down the euro's exchange rate just like the Bank of Japan has done with the yen's.

But this overlooks that a key reason for the drop in inflation is the way other central banks, particularly the Bank of Japan have lowered the value of their currencies, causing the euro's value to increase.

We need to remind ourselves of two things. First, how does "quantitative easing" increase price inflation? Well, there are many ways, but one of the most important causal mechanisms is by lowering its exchange rate. That will raise import prices, something that not only raises consumer prices directly but also indirectly by allowing domestic producers to raise their prices and by increasing the cost of imported inputs. Also higher nominal export earnings will put upward pressure on prices.

The second thing to remember is that exchange rates are a zero sum game. If one currency's exchange rate depreciate, a weighted average of the world's other exchange rates increases at the same rate. Thus, when Japan started to implement "Abenomics" it had a deflationary effect on other countries at the same time that it had an inflationary impact on Japan.

As I've noted before, between 2006 and 2012, the prices of Japanese imports to the U.S. rose by 1-2% per year, but during the latest year they have dropped by 2.8%

So if the ECB successfully emulated "Abenomics", the effect would be deflationary on all economies except the euro area (and the countries that pegs their currencies to the euro). That is not something I would view as bad, or at least not necessarily bad, but the pro-inflation non-euro area pundits that calls for the ECB to inflate would presumably dislike it.


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