Euro almost at it's introductory value vs the Dollar!

[Kidlicious]

It wasn't a ploy. The primary purpose of it was to use it as a spring board for further discussion. The secondary purpose was to stop this argument over whether there is such a thing as a key currency so that the discussion will improve.

[TCO]

I think just reading Spike's responses to Kid is a good way to follow the discussion. I recommend it to all.

Canned tuna mixed with chilled mild salsa for lunch. Bagle and cream cheese for breakfast.

[DrSpike]

Ok, since this is getting more civil now, and the quality of recent posts has risen, I'm going to repackage some of my earlier posts to try and show you why the things that you fear will not happen.

First regarding your viewpoint that loss of key currency status (and I give anyone the benefit of the doubt here, since the source material on page 1 is badly phrased) leads to loss of domestic monetary policy:

It is of course true that the state of the US economy impacts elsewhere, but it most definitely is not due to countries "being forced to ensure that their own currencies trade at stable rates against the dollar".
Posters that interpreted this as a country that lost 'key currency' status as losing control over domestic monetary policy are forgiven given this information, but of course it is not the case. Giving a concrete example US monetary policy will always be directed at domestic (not exchange rate) issues, since trade is a very small proportion of GDP.

(Added: as indeed GP was intimating at just above)

Despite talk by officials the exchange rate pretty much falls where it does........you can only hit one target with monetary policy and it is a domestic inflation target not an exchange rate target. This will not change no matter what happens to the value of the euro, I promise you.

Second: a bit on exchange rate determination.

(from a later post on exchange rate determination)

Supply and demand is certainly the way to think of it, with the result being the market exchange rate. Most understand this I think.

The part that is less understood is the link between the capital and current accounts and the exchange rate.
People demand dollars for 2 reasons:

1) indirectly to purchase US exports
2) to invest in US assets.

Start from a postion of balance. Now lets say the US growth rate improves making US assets more attractive. Capital flows into the US (this is an increased demand for dollars), the exchange rate appreciates, there is a capital account surplus and an offsetting current account deficit brought about by the increased cost of US exports in other countries.

Now the important point is that such capital flows DWARF in size everything else. Some factors mentioned in your post and elsewhere of course exist, like the dollars that may be used in countries where it is seen as a more stable currency than the legal tender there, but these factors in practice turn out to have minimal impact.

(added: this last paragraph is absolutely key to understanding why loss of key currency status will not lead to doom and gloom as you predicted. You don't have to believe me......AG makes exactly the same point about the primacy of capital flows resulting from differences in relative rates of return in exchange rate determination)

Third: On the potential benefits of a strong currency (and hence providing some thoughts on how loss of key currency status will impact upon the economy)

In recent years domestic savings in the US have not been sufficient to cover domestic investment. The gap is covered through capital inflows from the rest of the world, with a corresponding (exactly offsetting) trade deficit. The dollar has remained strong in the face of this deficit because the appetite of investors for US assets has not waned.........yet. (Added: AG also echoes this point)

Now in retrospect the strong currency (though as Fez and other correclty pointed out export dominated sectors like manufacturing will usually suffer when the currency is strong) has been a huge boon to the US, since it has allowed monetary policy to be looser than it otherwise would have been due to the reduced cost-push inflationary pressures.

So the strength of the dollar has largely been beneficial.......so is this the same as saying when that strength ends (as it may well do) the dollar loses key currency status and may suffer? Well personally I think its a generous interpretation, but if you want to peddle the key currency (added: doom and gloom) stuff the arguments above are the ones you are going to have to make.......the ones given in the initial quote and some made afterwards have little or no credibility.

Furthermore a weakening of the dollar at present provides a small push to aggregate demand at a time when AG is reluctant to use all his monetary firepower so close to the dreaded 0% nominal interest rate. I guess to close I'll say that neither strong nor weak currencies are always bad.......and usually they are strong or weak to reflect market conditions.

So there you have it.......as I said if you want to make a case for loss of key currency status being damaging you must understand the arguments above, and use them. However be aware that the case is not a good one. As I said in the closing point (and as someone else just said above) whether currencies are strong or weak reflects market conditions, either can be suitable for a given set of circumstances. So should the euro become more used doom and gloom does not necessarily follow.

AG ends on a nice upbeat note.........please remember that international trade is not a zero sum game.......the guiding principles is mutual advantage. Seeing the debate as a contest between the euro and the dollar immediately puts on the wrong track, and helps push you towards erroneous doom and gloom conclusions.

Hope this all helps.

[TCO]

(scratches head)

how can the capital influx both drive a high dollar and have an exactly counterbalancing trade deficit. Not arguing, just asking. Sensei. Sir.

[DrSpike]

GP:

Nice breakfast btw.

The simplest way to see it, is to start from balance in the classical model - no trade deficit, no capital inflow or outflow.......incidentally the position that would occur in autarky (no trade). The extra demand for dollars causes the dollar to appreciate, and there is a capital account surplus. But how far does the exchange rate appreciate? Well in these conditions the way to close the model is a simple one based around long term potential output, and the trade deficit brought about by the appreciation (exports down, imports up) exactly offsets the capital inflow by definition.

Some people don't like playing with silly long term models like the classical model......but unfortunately it is the case that without understanding these models one can never even hope to scratch the surface of the actual situation.

Incidentally the conclusion still holds in the most complex models we use........adjustments in the exchange rate will always ensure that total inflows equal total outflows.

[DrSpike]

Btw a nice presentation of the classical models can be found in Mankiw's Macroeconomics.........this is the one I make my students read.

For more complex models I recommend Krugman and Obstfeld's "International economics, theory and policy", which is an excellent text.

[Kidlicious]

I just got back from the dentist. He pulled one of my roots out. And he gave me some pain killers. So I may not be able to post much.

Just for the record though, I said that if the dollar were to completely lose its key currency status that there would be serious negative consequences for the US economy, and that the consequences would be so bad that they would affect the whole world. I did NOT say that if the Euro achieved key currency status along side the dollar that there would be serious consequences. No, the consequences would be negative, but only minimal.

So, God forbid, I don't agree with AG. I think that AG's opinion on the matter may be politically motivated. Let's assume that the Euro gains key currency status and the dollar retains some of its status as key currency. AG says that the competition would be good, but I disagree. Any competition between the two currencies would be bad and very dangerous. What would be needed would be cooperation not competition. Competition could lead to efforts by the central banks to strengthen their currency at the expense of the other currency and the actions that they take could be at odds with the actions that they should take to maintain the efficiency of their economy.

[TCO]

1. Can I handle Manikiw? Also does it explain macro in terms of micro? Is it the text or book you would recommend that I get? And buy it or interlibrary loan?

2. I thought about it a bit more and I guess I can understand what is happening. Suddenly growth opportunities increase. Same number of dollars in circulation. In autarky, the dollar would deflate (as if the amount of goods produced had increased. Just think of growth opptys as more goods.) So the exchange rate changes to show a more valuable dollar.

Taking off the autarky isolation curtail, capital flows in and imports increase because of behavioral elasticities. Some increased investment might happen in the US, but some would also occur from overseas.

Of course if the increased wealth opportunities are not at the expense of other countries (for instance if we were an OPEC country and the cartel got stronger) than it should have a deflationary effect on the world as a whole. And if they are false growth opportunities and people realize that, then that will be inflationary.

Am I thinking about this right?

[TCO]

I think you should understand the classical model before going to other models that involve changed assumptions. Because that way you understand what the effect of those changed assumptions are and can look at things differently depending on how much you deviate from the base case.

[OneFootInTheGrave]

huh this thread advanced nicely ... anyway what do you get for this

EU!

anyway if this happens it will be a first such situation after WWII... either that there are two key currencies or that the really Dollar looses significance internationally, but there is no way of that happening under normal circumstances...

[TCO]

I would think that the US has history (i.e. intertia, familiarity with the bills, etc.) helping it in retaining the key currency rating over the Euro. Also, I think it is a little safer/more stable. The ECB is doing a good job with the Euro and all. But it is a currency for 12 countries. There is some reasonable risk that the counries will leave the Euro or that fractious behavior may hurt the Euro somehow. I think there is less likelihood of that from individual US states.

[DrSpike]

Originally posted by GP
1. Can I handle Manikiw? Also does it explain macro in terms of micro? Is it the text or book you would recommend that I get? And buy it or interlibrary loan?

2. I thought about it a bit more and I guess I can understand what is happening. Suddenly growth opportunities increase. Same number of dollars in circulation. In autarky, the dollar would deflate (as if the amount of goods produced had increased. Just think of growth opptys as more goods.) So the exchange rate changes to show a more valuable dollar.

Taking off the autarky isolation curtail, capital flows in and imports increase because of behavioral elasticities. Some increased investment might happen in the US, but some would also occur from overseas.

Of course if the increased wealth opportunities are not at the expense of other countries (for instance if we were an OPEC country and the cartel got stronger) than it should have a deflationary effect on the world as a whole. And if they are false growth opportunities and people realize that, then that will be inflationary.

Am I thinking about this right?

2 first.......some of it looks ok, but I think the most important points are missing. The main difference between autarky and the open economy case is that domestic investment need not equal domestic saving. Furthermore the role of the interest rate in autarky is to adjust so that actual investment equals the stock of savings. In the (completely) open economy the interest rate is exogenous, the capital account deficit/surplus determined by desired investment and savings at the exogenous interest rate, and the exchange rate adjusts to balance current and capital accounts. All of that refers to classic long run models.......the short term models are more complex.

Also deflation refers to a fall in the general domestic price level. A fall in the value of a currency on the foreign exchange market is a depreciation.

1. If you want a macro text the Mankiw (N Gregory) one does everything from the ground up. However you then unwittingly asked about what is probably the most major schism in modern macro.

You see all basic macro is not built from microfoundations, that is individual consumers and producers intertemporally maximising.....it's just too complicated. Postgraduate macro is full of such models.........sometimes they are great (and eminently necessary to understand a given problem)......often they are not much use for practical purposes (though I get in trouble for saying things like that, so don't tell anyone. )

The macro it is critical to know if you want to understand the world economy better is the basic long run classical models, and the basic short run (IS-LM) models for both the closed and open economies. These models provide intuitive specification for, say, the relationship between investment and interest rates without worrying about each firm's investment decision. Of course this means none of these models have rigorous microfoundations, but learning how to use macro models with rigourous microfoundations is something that takes a long time.

[TCO]

I'm not necessarily looking for complicated math. (Although in the end, I want to know that someone did chase it all down with math.) I just want to be able to make sense of what people are saying in terms of supply and demand concepts.

wrt the deflation: I guess even before understanding the effect wrt trade, I want to understand the autarky case. If we have X dollars chasing Y goods and Y increases, than we have deflation, no? And the converse if X increases. Now say I make the growth opportunities more compelling (New Economy, myth or real). Assuming everything else constant (size of population, elasticities same) what happens to currency? Does it deflate? stay same?

[DrSpike]

There is little to no math in the models I want you to look at.........they are easy models with a massive payoff in terms of understanding if you can grasp them all and how they should be used together. Trust me, a touch of reading and you'll be able to run macroweenie rings around Roland, who has some grasp of economic statistics without the backbone of understanding he needs to use his knowledge well.

As to the rest I think I understand your point now......yes if there is a growth in productive capacity with constant money supply in autarky then there is deflationary pressure, which may just manifest itself in lower inflation. However in reality of course the central bank would increase the money supply to hit it's inflation target and give a further short term boost.

[Kidlicious]

I'm not Roland btw