Foreign Exchange Rates : The Fundamental issues

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    By jenniwings

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    The fundamental issue is that an Foreign Exchange Rate is a price, the price of one currency in terms of another currency. A weaker currency tends to favor exporters, because their production costs in the domestic currency are lower compared to the revenue they gain when selling in a foreign currency.
    A stronger currency tends to favor importers, because they can afford to buy more goods in the supermarket that is the world economy.

    Of course, the reality is that the US economy has all kinds of different players, some of whom would benefit from a stronger Foreign Exchange Rate and some of whom would benefit from a weaker Foreign Exchange Rate. Think about the difference between a firm that imports inputs, uses them in production, and re-exports much of the output, as opposed to a form that imports goods that are sold directly to US consumers.

    In short, every time the US Foreign Exchange Rate moves, for whatever reason, there will be a mixed bag of those who benefit and those who are harmed. A weaker currency is the economic equivalent of combining a higher tax that hinders consumption, like the higher value-added (or sales) tax, with an offsetting cut in a tax that lowers costs of domestic production, like the lower payroll tax. If the policy goal is to help US exporters, but not to impose costs on US importers and consumers, then seeking a lower US dollar Foreign Exchange Rate is the wrong policy tool. It is a mirage (and a fundamental confusion) to argue that some change in the dollar Foreign Exchange Rate will be all benefits and no costs for the US economy.

    Just to be clear, I'm certainly not arguing that Foreign Exchange Rates are never "too high" or "too low"; it's clear that Foreign Exchange Rates are volatile and can have bubbles and valleys.

    Nor am I arguing that countries never try to manipulate their Foreign Exchange Rates; indeed, I would argue that every country manipulates its Foreign Exchange Rates in one way or another. If countries allow their Foreign Exchange Rates to float, then when the central bank adjusts interest rates or allows a chance in inflation or stimulates an economy, the Foreign Exchange Rate is going to shift, which is clearly a way in which Foreign Exchange Rates are manipulated by policy. If countries don't let their Foreign Exchange Rates move, that's clearly a form of manipulation. And if countries allow their Foreign Exchange Rates to move, but act to limit big swings in those movements, that is also manipulation.

    What I am arguing is that given even a basic notion how Foreign Exchange Rate markets work and the economic forces that affect Foreign Exchange Rates, it is opaque how "non-manipulation" would work. Are Foreign Exchange Rates going to be held stable across countries, even in the face of cross-national economic changes in interest rates, inflation, and growth? A wide variety of experience, including the breakdown of the Bretton Woods agreement in the early 1970s and the current problems with euro, suggest that holding Foreign Exchange Rates stable is impractical over time and can have some very bad consequences. But if Foreign Exchange Rates are going to be allowed to move, then the question arises of who decides when and how much. Most national governments, especially after having watched the euro in action, will want to keep some power over Foreign Exchange Rates. There are serious people who discuss what kind of international agreements and cooperation it would take to have greater Foreign Exchange Rate stability, but it's a hard task, and squawking about how all Foreign Exchange Rates are bad--stronger, weaker, moving, stable--is not a serious answer.

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