Currency Manipulation

Now let’s consider the topic
of currency manipulation. That’s somewhat of an inflammatory name, you’ll also hear this often called
currency intervention. The most common case
of currency manipulation or intervention, is when a country tries to hold down
the value of its currency, and they will do that by
buying and selling foreign exchange in global markets. There are a few different ways
we can draw this, but let’s say we have a demand curve
for a currency, and a fixed supply curve. On the vertical axis, we have
the exchange rate for that currency, and on the horizontal axis,
we have the quantity. What a central bank can do is
increase the quantity of that money therefore, shifting out the supply curve
will have a new point of intersection and that will mean a lower exchange rate. Keep in mind that if the central bank
is taking that new money and using it to buy foreign currency, you can also show in the market
for that foreign currency that the demand for that currency
is going up, and the exchange rate
for the other currency is going up, and thus again, the exchange rate
for the domestic currency is going down. So why would a country want to lower
its exchange rate in this fashion? Well, the immediate impact
of the lower exchange rate is to make exports of that country
cheaper on world markets. And the goal very often is
to lower the exchange rate, boost those exports, and in the longer run
boost rates of economic growth. Think of this as an export-led
development strategy and it is partially implemented by
currency intervention or manipulation. Of course, currency manipulation
does not create new wealth, but rather, it’s redistributing wealth. It’s an implicit subsidy
to business exporters and an implicit tax on consumers
who are buying importers. One way to think about
how this might possibly work, is to imagine an economy where
you need a more commercial, or more business-oriented
set of interest groups, and that initially by subsidizing
some of your exporters, even though that’s inefficient
in a lot of standard economic models, what you might be doing
is growing your middle class, growing your commercial class,
and over time, this might give you
a better economic policy. That maybe sounds a little strange
but if we look at history, we do actually find
a few cases where it seems this has definitely worked. And those cases would be Japan,
South Korea, and also China. Those are countries which deliberately
kept their exchange rates low, this helped their export-led growth,
and overtime those countries became much wealthier. Of course, it’s not really
as simple as all that. The initial decline of the exchange rate
through currency intervention means that there’s more
of the domestic currency out there. Over time, this tends to push up prices
in the domestic country and that means that over time,
that country tends to lose it’s initial exchange rate advantage
from the currency manipulation. For more on exactly
how this process works see a video on nominal
verses real exchange rates. Sometimes governments or central banks
engage in what is called sterilization to prevent this new inflation
from coming into effect. So, if we see here that a government
increases the money supply, for the purposes of manipulating
an exchange rate, to limit the inflation, the government
has to pull that new money back out of the market
and they will do that basically by selling bonds
or some other asset thus bringing the money supply
back to it’s initial level, and indeed, if you sterilize
in this fashion it means the inflation
will not happen. But think, what are you doing here? By selling more bonds,
the government is borrowing money. This pulls resources out
of the real economy. It means higher taxes
either now or later, and this means,
that currency sterilization imposes a very real burden
on the citizenry in terms of fewer real goods
and services in the economy. So, does manipulating
the real exchange rate in this entire manner actually work?
Well, it depends. What you’re getting is a situation
where imports are more expensive, that’s a burden on citizens. You’re redistributing resources to your
corporate sector and your exporters, and basically, I would say,
that this strategy is dubious unless it’s going to be accompanied
by some kind of growth miracle. So, definitely it has worked for Japan,
South Korea and China, but that doesn’t mean
it’s a general formula by which countries can become
more prosperous. For more on this topic
I recommend first of all, are videos on real and nominal
exchange rates, and also are specific video
on Chinese currency manipulation. There’s a good piece by Sarno and Taylor
available online. You can also Google
some related topics listed here and see also Danny Rodriks piece, “The real exchange rate
and economic growth.”

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