The exchange rate is the most important price in any economy, since it affects all other prices. Exchange rates are set, either directly or indirectly, by government policy. Exchange rates are also central to the global economy, for they profoundly influence all international economic activity. Despite the critical role of exchange rate policy, there are few definitive explanations of why governments choose the currency policies they do. Filled with in-depth cases and examples, Currency Politics presents a comprehensive analysis of the politics surrounding exchange rates.
Identifying the motivations for currency policy preferences on the part of industries seeking to influence politicians, Jeffry Frieden shows how each industry's characteristics—including its exposure to currency risk and the price effects of exchange rate movements—determine those preferences. Frieden evaluates the accuracy of his theoretical arguments in a variety of historical and geographical settings: he looks at the politics of the gold standard, particularly in the United States, and he examines the political economy of European monetary integration. He also analyzes the politics of Latin American currency policy over the past forty years, and focuses on the daunting currency crises that have frequently debilitated Latin American nations, including Mexico, Argentina, and Brazil.
With an ambitious mix of narrative and statistical investigation, Currency Politics clarifies the political and economic determinants of exchange rate policies.
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The Political Economy of Exchange Rate Policy
By Jeffry A. Frieden
PRINCETON UNIVERSITY PRESSCopyright © 2015 Princeton University Press
All rights reserved.
A Theory of Currency Policy Preferences
This study emphasizes the distributionally motivated currency policy preferences of economic actors—firms, industries, and groups. It argues that characteristics of an industry, including its exposure to exchange rate risk and the relative price effects of exchange rate movements, determine its exchange rate policy preferences. Because in an open economy the exchange rate affects all national economic actors, understanding the making of currency policy requires a more or less complete map of the national political economy.
There are two relevant dimensions of exchange rate policy choice: the regime (fixed or floating) and the level (appreciated or depreciated). With regard to the former, I contend that actors that rely heavily on international trade, investment, or financial ties will, all else being equal, prefer a stable exchange rate—the gold standard, fixed rates, dollarization, and euroization—which reduces the currency risk associated with their international activities. With regard to the latter, I maintain that tradables producers will, all else being equal, prefer a depreciated exchange rate, which raises the relative price of their products, while producers of nontradable goods and services have opposing interests. I expect that the degree to which exchange rate movements are passed through to local prices will have an important impact on policy preferences. Producers of goods with limited pass-through (due to substantial product differentiation, for example) will be more favorable to a fixed exchange rate and less favorable to a depreciated currency. There are many ways to add nuance and complexity to this analysis, but I will try to rely on these three factors—international exposure, tradability, and pass-through—to explain as much of currency policy preferences as I can. I believe that this can provide building blocks for a broader analysis of the politics of exchange rates.
The rest of this chapter develops my argument in detail. It starts with a statement of the things I am trying to explain—the dependent variables of the study. I then present my reasoning and the empirical expectations that flow from it. This is followed by a brief summary of other scholarly studies of the economics and politics of exchange rates in order to situate this study within the broader literature
The Dependent Variable: Interests in the Exchange Rate
I am interested in explaining the currency policy preferences of domestic socioeconomic groups. This is a limited goal. Even were it fully achieved, it would not supply enough information to clarify national government policy preferences, which also depend on national political institutions and domestic political bargaining. Nor is it sufficient to explain policy outcomes, which depend on national conditions and international circumstances. But understanding the policy preferences of socioeconomic actors, especially firms, industries, and other economic interest groups, is a necessary first step.
The literature on the politics of trade policy offers a parallel. Trade policy, too, is the result of the preferences of domestic socioeconomic actors, domestic and international political and economic institutions, interstate strategic interaction, and a myriad of other things. Yet nobody would question the centrality of understanding how different trade policies affect firms, workers, and other social groups. Indeed, a massive literature on the political economy of trade focuses on how best to understand the distributional impact of different trade policies.
In the same way, I am interested in understanding the differential impact of international monetary policies on society, given that a proper understanding of the interests of social actors is essential to further analysis. We cannot understand the motivations of policymakers without knowing the pressures and demands they face from their constituents. However we analyze international monetary policy, we need some notion of how policy affects society.
The need for microfoundations for the analysis of international monetary policy can be seen in many contexts. For example, it is common for analysts to assert that a particular currency is "unsustainable." But no nominal exchange rate is technically impossible to sustain: the national economy can always be forced to conform to the exchange rate by driving wages and prices down; in fact, it was common for governments to do this to stay on the gold standard. What is typically meant by unsustainability is that such attempts would be politically impossible to maintain in the face of domestic opposition. This implies that the analyst has some notion of what these political constraints are. And the constraints vary from place to place and time to time: one government may not be able to sustain an exchange rate that might well be sustained by another one.
An understanding of the societal interests affected by international monetary policy is central to any analysis of such policy. The goal of this book is to help specify the societal interests that form the building blocks of national currency policies and international monetary systems.
Determinants of Exchange Rate Policy Preferences
I derive the exchange rate policy preferences of economic actors from their economic characteristics. As above, the issue can be divided into two dimensions: the currency regime and its level. The two dimensions are interrelated in practice—a fixed currency cannot be devalued, of course—but can be treated separately for ease of exposition.
Preferences over the Exchange Rate Regime
Those who consider currency risk as more important will, all else being equal, favor a fixed exchange rate; those who view currency risk as relatively less of a consideration will prefer a floating rate. This means that exposure to exchange rate volatility is a principal determinant of support for a fixed currency. Stabilizing exchange rates is primarily significant to those who deal with cross-border trade and payments. On the other hand, those whose businesses are entirely domestic have little reason to want the government to tie its hands to stabilize a price—that of the currency—that is of no direct importance to them.
Exposure to exchange rate volatility usually depends on involvement in international trade, finance, and investment. An enterprise that relies heavily on earnings from exports or foreign production, or is a substantial user of imported inputs or capital, can be hard hit by exchange rate fluctuations. Multinational corporations with facilities in several currency areas can have their business disrupted by unexpected exchange rate movements. In addition, investment planning can be hampered by uncertainty about the exchange rate. If foreign labor costs in a host country, measured in the home currency, rise substantially solely because the exchange rate moves, it can be costly for a multinational firm.
In all these instances, the time horizon of currency exposure matters. So too does the availability of opportunities to ensure against foreign exchange risk, especially forward-currency markets. Small and poor countries typically have thin forward markets, so that hedging is difficult, expensive, or impossible. Even where forward markets are well developed, they cannot inexpensively provide complete protection against currency movements. This means that in virtually all circumstances, the most serious risks are borne by those with long-term nominal commitments in foreign currency. These commitments might be explicit or implicit contracts to deliver or purchase goods in return for a fixed amount of foreign currency, or debt contracts denominated in foreign currency. Substantial exchange rate movements can be risky in these cases. On the other hand, firms whose goods are traded on spot markets or investors with assets that can be liquidated easily are less exposed to currency risk. So firms with long-term currency exposure will be concerned to stabilize exchange rates. These firms include, most prominently, exporters or importers with long-term contracts denominated in foreign currency, and those with long-term foreign-currency investments. This gives rise to the following empirical implications, all of which require the usual "all being else equal" modifier:
The greater a firm's involvement in cross-border trade and investment, the greater its support for a fixed exchange rate
For a firm heavily engaged in international trade and investment, support for a fixed exchange rate will increase with
its reliance on long-term implicit or explicit contracts denominated in foreign currency
the length of its investment horizons
These implications can be translated into more descriptive expectations. Exporters of complex manufactured products, multinational corporations, and international banks can all be expected to be particularly interested in policies to stabilize exchange rates, as can foreign-currency debtors. The empirical work that follows evaluates as many of these expectations as can be assessed given the state of the data.
Preferences over the Level of the Exchange Rate
Whether the national currency is fixed or floating, or something in between, is an important decision; so too is the level of the currency's value. More accurately, it is the real exchange rate—the relationship between domestic and foreign price levels—that has to be amenable to government policy for policy preferences to make any difference. If national price levels adjusted quickly to nominal exchange rate movements—as they have in societies with long-term high inflation or a full indexing—then exchange rate policy would have little or no impact on relative foreign as well as domestic prices. Whether this holds in other societies is an empirical question.
In fact, there is overwhelming evidence for substantial deviations from purchasing power parity (PPP)—the relationship between the domestic and foreign price levels that would make national consumption baskets roughly equal in price—for long periods of time. Recent estimates indicate that the half-life of deviations from PPP—the period in which prices and exchange rates change to eliminate half the difference in the two countries' price levels—range from about three to over seven years. Even the shorter period is a long time in macroeconomic terms, and an eternity—or election—in political terms.
There is also strong evidence that nominal exchange rate movements are major causes of these substantial real exchange rate changes. All of this is simply to say that government policy is capable of affecting the real exchange rate for a long enough time to matter to economic agents and the economy as a whole. This is important for our purposes, because if national policy did not have this capability it would be hard to justify a study of it.
Understanding firm interests in the currency's level is simplified with a survey of basic exchange rate economics. The standard approach to exchange rates, used as the foundation for the analysis here as well, is the Mundell-Fleming-Dornbusch framework. Typically, it regards the national currency as an asset, and assumes that asset prices adjust more rapidly than goods prices. Thus, currency markets adjust more quickly to news about monetary policy than do goods markets. Another crucial and related component of the model is that monetary policy leads the currency to overshoot, which implies both interest rate and exchange rate effects of monetary policy.
When, for example, the monetary authorities increase the rate of growth of the money supply, interest rates decline and investors sell off the currency. In the Dornbusch overshooting model, the currency falls by more than the change in monetary policy would imply, so that investors now expect a future currency appreciation. This makes investors willing to hold the currency at the lower prevailing interest rate, as they will be compensated for the interest rate differential between home and foreign markets by the capital gain reaped when the currency rises in value. This approach, which is widely enough accepted to be the standard fare of most textbooks, shows how monetary policy can lead to changes in nominal exchange and interest rates, and (along with the assumption of sticky prices) demonstrates how currency movements can have real effects on relative prices.
Economic analysis goes on to investigate the macroeconomic impact of currency movements. There are income effects, which induce expenditure reduction, as well as substitution effects, which induce expenditure switching. The former effects operate as a decline in the currency's value (in the case of a depreciation) to reduce real purchasing power in world prices, so that real disposable income is lower and domestic expenditures go down. The latter effects run through the relative price impact of a depreciation, thereby leading consumers to substitute domestic products for previously imported (now more expensive) goods, switching consumption from imports to domestic output. The aggregate macroeconomic impact of the two effects depends very much on the country's economic structure and starting position.
Exchange rate economics is only raw material for our concerns. Given that the authorities can affect the real exchange rate, we want to know its impact on relative prices, and how this influences economic agents. For this purpose, an approach to the real exchange rate based on the relationship between tradable and nontradable goods and services is particularly useful.
The real exchange rate (RER) is usually expressed as the relationship between the national and foreign price levels, expressed in the home currency, as follows:
RER = e [P/P*],
where e is the nominal exchange rate expressed in units of foreign currency per unit of domestic currency, P is the domestic price level, and P* is the world (foreign) price level. As this indicates, the real exchange rate can change because the nominal exchange rate changes. The real exchange rate can also change without a nominal currency movement, when the relationship between the national and foreign price levels change. A rise in the local price level relative to world prices leads to a real appreciation, while a rise by less than that of world prices leads to a real depreciation.
Alternatively, the real exchange rate can be expressed in terms of tradable and nontradable goods and services. Tradable goods are those that enter freely into world trade, while nontradable goods and services are those consumed where they are produced. Tradability can be the result of transport costs or other inherent features of products that make them difficult or impossible to sell across borders. Housing, restaurant meals, education, health care, and haircuts are typical examples. Tradability is relative, not absolute. Belgians buy homes in the Netherlands and commute, Southern Californians get their hair cut in Mexico, and foreigners come to the United States for medical and educational services. In addition, many nontradables use substantial tradable inputs, such as construction materials in housing, which can lead their prices to be linked. Much evidence exists, however, that the tradables/nontradables definition of the real exchange rate captures many of the relevant relative price characteristics of exchange rate movements.
In this framework, the prices of tradable goods are set in world markets, while the prices of nontradable goods and services are set domestically. In other words, national policy cannot affect the world price of tradables, expressed in foreign currency; tradables prices are thus an anchor for the real exchange rate. When the national currency depreciates (appreciates), tradable prices expressed in the home currency go up (down) proportionately. When the peso-to-dollar exchange rate is twenty to one, and a lamp trades for ten dollars on world markets, it costs two hundred pesos; if the peso is devalued to thirty to one, the lamp costs three hundred pesos.
Excerpted from Currency Politics by Jeffry A. Frieden. Copyright © 2015 Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS.
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Table of ContentsPreface vii
Introduction The Political Economy of Currency Choice 1
Chapter 1 A Theory of Currency Policy Preferences 19
Chapter 2 The United States: From Greenbacks to Gold, 1862–79 49
Chapter 3 The United States: Silver Threats among the Gold, 1880–96 104
Chapter 4 European Monetary Integration: From Bretton Woods to the Euro and Beyond 137
Chapter 5 Latin American Currency Policy, 1970–2010 186
Chapter 6 The Political Economy of Latin American Currency Crises 220
Chapter 7 The Politics of Exchange Rates: Implications and Extensions 246
What People are Saying About This
"This is international political economy as it should be. Frieden presents a sturdy framework that shows why various interest groups ought to favor strong or weak currencies, and stable or flexible exchange rates. His book's convincing applications of this framework range from sectional politics in nineteenth-century America, to today's eurozone divisions, to the vicissitudes of emerging markets."Jeffrey Frankel, Harvard University