Currency Depreciation and Monetary Expansion Redux

Last week Frances Coppola and I exchanged posts about competitive devaluation. Frances chided me for favoring competitive devaluation, competitive devaluation, in her view, accomplishing nothing in a world of fiat currencies, because exchange rates don’t change. Say, the US devalues the dollar by 10% against the pound and Britain devalues the pound by 10% against the dollar; it’s as if nothing happened. In reply, I pointed out that if the competitive devaluation is achieved by monetary expansion (the US buying pounds with dollars to drive up the value of the pound and the UK buying dollars with pounds to drive up the value of the dollar), the result must be  increased prices in both the US and the UK. Frances responded that our disagreement was just a semantic misunderstanding, because she was talking about competitive devaluation in the absence of monetary expansion; so it’s all good.

I am, more or less, happy with that resolution of our disagreement, but I am not quite persuaded that the disagreement between us is merely semantic, as Frances seems conflicted about Hawtrey’s argument, carried out in the context of a gold standard, which served as my proof text for the proposition that competitive devaluation really is expansionary. On the one hand, she seems to distinguish between the expansionary effect of competitive devaluation relative to gold – Hawtrey’s case – and the beggar-my-neighbor effect of competitive devaluation of fiat currencies relative to each other; on the other hand, she also intimates that even Hawtrey got it wrong in arguing that competitive devaluation is expansionary. Now, much as I admire Hawtrey, I have no problem with criticizing him; it just seems that Frances hasn’t decided whether she does – or doesn’t – agree with him.

But what I want to do in this post is not to argue with Frances, though some disagreements may be impossible to cover up; I just want to explain the relationship between competitive devaluation and monetary expansion.

First some context. One of the reasons that I — almost exactly four years ago – wrote my post about Hawtrey and competitive devaluations (aka currency wars) is that critics of quantitative easing had started to make the argument that the real point of quantitative easing was to gain a competitive advantage over other countries by depreciating – or devaluing – their currencies. What I was trying to show was that if a currency is being depreciated by monetary expansion (aka quantitative easing), then, as Frances now seems – but I’m still not sure – ready to concede, the combination of monetary expansion and currency devaluation has a net expansionary effect on the whole world, and the critics of quantitative easing are wrong. Because the competitive devaluation argument has so often been made together with a criticism of quantitative easing, I assumed, carelessly it appears, that in criticizing my post, Frances was disagreeing with my support of currency depreciation in the context of monetary expansion and quantitative easing.

With that explanatory preface out of the way, let’s think about how to depreciate a fiat currency on the foreign exchange markets. A market-clearing exchange rate between two fiat currencies can be determined in two ways (though there is often a little of both in practice): 1) a currency peg and 2) a floating rate. Under a currency peg, one or both countries are committed to buying and selling the other currency in unlimited quantities at the pegged (official) rate. If neither country is prepared to buy or sell its currency in unlimited quantities at the pegged rate, the peg is not a true peg, because the peg will not withstand a sufficient shift in the relative market demands for the currencies. If the market demand is inconsistent with the quasi-peg, either the pegged rate will cease to be a market-clearing rate, with a rationing system imposed while the appearance of a peg is maintained, or the exchange rate will be allowed to float to clear the market. A peg can be one-sided or two-sided, but a two-sided peg is possible only so long as both countries agree on the exchange rate to be pegged; if they disagree, the system goes haywire. To use Nick Rowe’s terminology, the typical case of a currency peg involves an alpha (or dominant, or reserve) currency which is taken as a standard and a beta currency which is made convertible into the alpha currency at a rate chosen by the issuer of the beta currency.

With floating currencies, the market is cleared by adjustment of the exchange rate rather than currency purchases or sales by the monetary authority to maintain the peg. In practice, monetary authorities generally do buy and sell their currencies in the market — sometimes with, and  sometimes without, an exchange-rate target — so the operation of actual foreign exchange markets lies somewhere in between the two poles of currency pegs and floating rates.

What does this tell us about currency depreciation? First, it is possible for a country to devalue its currency against another currency to which its currency is pegged by changing the peg unilaterally. If a peg is one-sided, i.e., a beta currency is tied to an alpha, the issuer of the beta currency chooses the peg unilaterally. If the peg is two-sided, then the peg cannot be changed unilaterally; the two currencies are merely different denominations of a single currency, and a unilateral change in the peg means that the common currency has been abandoned and replaced by two separate currencies.

So what happens if a beta currency pegged to an alpha currency, e.g., the Hong Kong dollar which pegged to the US dollar, is devalued? Say Hong Kong has an unemployment problem and attributes the problem to Hong Kong wages being too high for its exports to compete in world markets. Hong Kong decides to solve the problem by devaluing their dollar from 13 cents to 10 cents. Would the devaluation be expansionary or contractionary for the rest of the world?

Hong Kong is the paradigmatic small open economy. Its export prices are quoted in US dollars determined in world markets in which HK is a small player, so the prices of HK exports quoted in US dollars don’t change, but in HK dollars the prices rise by 30%. Suddenly, HK exporters become super-profitable, and hire as many workers as they can to increase output. Hong Kong’s unemployment problem is solved.

(Brief digression. There are those who reject this reasoning, because it supposedly assumes that Hong Kong workers suffer from money illusion. If workers are unemployed because their wages are too high relative to the Hong Kong producer price level, why don’t they accept a cut in nominal wages? We don’t know. But if they aren’t willing to accept a nominal-wage cut, why do they allow themselves to be tricked into accepting a real-wage cut by way of a devaluation, unless they are suffering from money illusion? And we all know that it’s irrational to suffer from money illusion, because money is neutral. The question is a good question, but the answer is that the argument for monetary neutrality and for the absence of money illusion presumes a comparison between two equilibrium states. But the devaluation analysis above did not start from an equilibrium; it started from a disequilibrium. So the analysis can’t be refuted by saying that it implies that workers suffer from money illusion.)

The result of the Hong Kong export boom and corresponding increase in output and employment is that US dollars will start flowing into Hong Kong as payment for all those exports. So the next question is what happens to those dollars? With no change in the demand of Hong Kong residents to hold US dollars, they will presumably want to exchange their US dollars for Hong Kong dollars, so that the quantity of Hong Kong dollars held by Hong Kong residents will increase. Because domestic income and expenditure in Hong Kong is rising, some of the new Hong Kong dollars will probably be held, but some will be spent. The increased spending as a result of rising incomes and a desire to convert some of the increased cash holdings into other assets will spill over into increased purchases by Hong Kong residents on imports or foreign assets. The increase in domestic income and expenditure and the increase in import prices will inevitably cause an increase in prices measured in HK dollars.

Thus, insofar as income, expenditure and prices are rising in Hong Kong, the immediate real exchange rate advantage resulting from devaluation will dissipate, though not necessarily completely, as the HK prices of non-tradables including labor services are bid up in response to the demand increase following devaluation. The increase in HK prices and increased spending by HK residents on imported goods will have an expansionary effect on the rest of the world (albeit a small one because Hong Kong is a small open economy). That’s the optimistic scenario.

But there is also a pessimistic scenario that was spelled out by Max Corden in his classic article on exchange rate protection. In this scenario, the HK monetary authority either reduces the quantity of HK dollars to offset the increase in HK dollars caused by its export surplus, or it increases the demand for HK dollars to match the increase in the quantity of HK dollars. It can reduce the quantity of HK dollars by engaging in open-market sales of domestic securities in its portfolio, and it can increase the demand for HK dollars by increasing the required reserves that HK banks must hold against the HK dollars (either deposits or banknotes) that they create. Alternatively, the monetary authority could pay interest on the reserves held by HK banks at the central bank as a way of  increasing the amount of HK dollars demanded. By eliminating the excess supply of HK dollars through one of more of these methods, the central bank prevents the increase in HK spending and the reduction in net exports that would otherwise have occurred in response to the HK devaluation. That was the great theoretical insight of Corden’s analysis: the beggar-my-neighbor effect of devaluation is not caused by the devaluation, but by the monetary policy that prevents the increase in domestic income associated with devaluation from spilling over into increased expenditure. This can only be accomplished by a monetary policy that deliberately creates a chronic excess demand for cash, an excess demand that can only be satisfied by way of an export surplus.

The effect (though just second-order) of the HK policy on US prices can also be determined, because the policy of the HK monetary authority involves an increase in its demand to hold US FX reserves. If it chooses to hold the additional dollar reserves in actual US dollars, the increase in the demand for US base money will, ceteris paribus, cause the US price level to fall. Alternatively, if the HK monetary authority chooses to hold its dollar reserves in the form of US Treasuries, the yield on those Treasuries will tend to fall. A reduced yield on Treasuries will increase the desired holdings of dollars, also implying a reduced US price level. Of course, the US is capable of nullifying the deflationary effect of HK currency manipulation by monetary expansion; the point is that the HK policy will have a (slight) deflationary effect on the US unless it is counteracted.

If I were writing a textbook, I would say that it is left as an exercise for the reader to work out the analysis of devaluation in the case of floating currencies. So if you feel like stopping here, you probably won’t be missing very much. But just to cover all the bases, I will go through the argument quickly. If a country wants to drive down the floating exchange rate between its currency and another currency, the monetary authority can buy the foreign currency in exchange for its own currency in the FX markets. It’s actually not necessary to intervene directly in FX markets to do this, issuing more currency, by open-market operations (aka quantitative easing) would also work, but the effect in FX markets will show up more quickly than if the expansion is carried out by open market purchases. So in the simplest case, currency depreciation is actually just another term for monetary expansion. However, the link between monetary expansion and currency depreciation can be broken if a central bank simultaneously buys the foreign currency with new issues of its own currency while making open-market sales of assets to mop up the home currency issued while intervening in the FX market. Alternatively, it can intervene in the FX market while imposing increased reserve requirements on banks, thereby forcing them to hold the newly issued currency, or by paying banks a sufficiently interest rate on reserves held at the central bank to willingly hold the newly issued currency.

So, it is my contention that there is no such thing as pure currency depreciation without monetary expansion. If currency depreciation is to be achieved without monetary expansion, the central bank must also simultaneously either carry out open-market sales to mop the currency issued in the process of driving down the exchange rate of the currency, or impose reserve requirements on banks, or pay interest on bank reserves, thereby creating an increased demand for the additional currency that was issued to drive down the exchange value of the home currency

14 Responses to “Currency Depreciation and Monetary Expansion Redux”


  1. 1 JKH February 26, 2016 at 1:40 am

    “By eliminating the excess supply of HK dollars through one of more of these methods, the central bank prevents the increase in HK spending and the reduction in net exports that would otherwise have occurred in response to the HK devaluation… so, it is my contention that there is no such thing as pure currency depreciation without monetary expansion. If currency depreciation is to be achieved without monetary expansion, the central bank must also simultaneously either carry out open-market sales to mop the currency created in the process of depreciating the currency, or impose reserve requirements on banks, or pay interest on bank reserves, thereby create a demand for the additional currency that was issued while the exchange value of the currency was being driven down.”

    That second part seems like a non sequitur. But in any case – repeating my comment from the prior post, the monetary authority has no choice but to resort to one of “these methods” in order to maintain control of the domestic policy interest rate (i.e. normally a short term positive rate). If that reaction is defined as “sterilization”, then the monetary authority has no option but to sterilize. The premise of there being an alternative is incorrect, as it is a factual matter of the balance sheet operational mechanics that are required to manage the policy rate. Otherwise, banks with uncompensated excess reserves will chase short term positive rates down to zero. (The same zero-chasing arbitrage will occur at negative rates, and the case of a zero interest rate is moot.) I’ve lost track of the common ground or not between you and Coppola in the debate, but the fact of the required monetary response is prerequisite.

  2. 2 David Glasner February 26, 2016 at 6:55 am

    JKH, Sorry, I don’t understand your comment at all. What exactly is the non-sequitur you see? A central bank always has a choice about whether it wants to increase the size of its balance sheet by accumulating FX reserves. Did the Bank of France not have a choice in 1928 to start accumulating gold. Did France not have a choice about whether to restore convertibility at the market rate of exchange between the franc and the dollar or to restore convertibility at less than the prevailing rate of exchange?

  3. 3 JKH February 26, 2016 at 7:13 am

    David,

    I didn’t understand this:

    “it is my contention that there is no such thing as pure currency depreciation without monetary expansion. If currency depreciation is to be achieved without monetary expansion, the central bank must …”

    If there is no such thing as X, how can you qualify the achievement of X?

    I’m certainly not questioning the possibility of balance sheet expansion in the form of FX reserves.

  4. 4 dberg642 February 26, 2016 at 7:44 am

    If one were to substitute Chinese rmb for HK $, the argument (with appropriate tweaks) still works. Yes?

  5. 5 Rob Rawlings February 26, 2016 at 7:58 am

    Oddly enough , when I started reading the post I would have agreed that “there is no such thing as pure currency depreciation without monetary expansion”.

    However having learned from your post the various ways that CBs might sterilize devaluations to eliminate the monetary expansion, I suspect that is probably what most governments intend when they devalue their currency – they think they can gain competitive advantage but minimize any inflationary side-effects. Otherwise they could just expand the monetarily base by buying something other than a foreign currency, right ?

    To that extent sterilized devaluations are both “beggar-thy-neighbor” and likely to fail if others retaliate.

  6. 6 Miguel Navascués February 26, 2016 at 11:27 am

    So, sterilization of internal effects of devaluation is not possible, I think. If it were, the EMS crisis would haven’t happen: the problem was the extreme contradiction between internal and external objective. As always everywhere. Good post, David

  7. 7 Miguel Navascués February 26, 2016 at 11:53 am

    … And in relation to monetary illusion, obviously. That is the clue of the famous Friedman’s article of 1953, “The case for flexible exchange rate”.

  8. 8 Henry February 26, 2016 at 2:18 pm

    It seems to me this discussion has devolved into a bit of a muddle.

    We have David and Frances debating different issues – does it include monetary expansion or not. There is the confusion over whether the discussion is about the Gold Standard in general or the experience of Britain after leaving gold (hence all the Hawtrey extracts), a floating exchange rate system or a fixed exchange rate system.

    The other shifting sand this discussion stands on is the question of what is the aim of the devaluation/depreciation – is it internal balance (i.e. maintenance of some balance of national income/employment/inflation) or is it about external balance (i.e. maintenance of the balance of trade or of the balance of payments overall, i.e including capital flows).

    And the other feature that seems to slide in and out of the discussion is that it began with the notion of competitive devaluation, i.e. a situation in which other countries respond to a country’s devaluation/depreciation. How internal policy responses proceed depends on how other countries respond.

    This discussion might be helped by considering the traditional analysis approach which centres around the Swan Diagram analysis in the case of trade flows only or the Mundell-Flemming model which includes capital flows.

    It seems to me before David can say “So, it is my contention that there is no such thing as pure currency depreciation without monetary expansion. ” he has at least to clearly specify what the goals of policy are, viz. either some change to internal balance or external balance or both.

  9. 9 Henry February 26, 2016 at 4:59 pm

    In said in my previous that the discussion was getting confused, I probably should say that I’m the one that’s confused. 🙂

  10. 10 David Glasner February 27, 2016 at 8:41 pm

    JKH, Perhaps I didn’t phrase it well. My point is that a country with a fiat currency cannot depreciate its currency without taking some action that simultaneously causes a monetary expansion. It is possible to for the country to take additional actions that will undo or reverse the monetary expansion, but monetary expansion is the automatic consequence of currency depreciation.

    dberg642, Yes. Whether the Chinese have in fact engaged in such conduct is a question that I have discussed in previous posts a year or two ago on currency manipulation.

    Rob, I wouldn’t make any generalizations about why countries depreciate their currencies, but I don’t think your inference is unreasonable.

    Miguel, I’m not sure what you mean by sterilization of internal effects of devaluation. I agree with you about Friedman’s flexible exchange rate article. But there may be an inconsistency between that article and his 1968 article about monetary policy and the natural rate of unemployment.

    Henry, You are correct that there are a lot of moving parts. I am just focusing on one part. To cover all the parts would take much more than one — already overly long — blog post.

  11. 11 JKH February 27, 2016 at 11:45 pm

    David,

    Unfortunately, you’ve completely missed (apparently) my main point while focusing on a minor comment I included about sentence construction. The main point is that it is operationally IMPOSSIBLE for the country NOT to take additional actions that will undo or reverse the monetary expansion – according to the way in which you have explicitly defined the corresponding set of “possible” reversing actions. Otherwise, short term interest rates go to zero, according to how banking system arbitrage must operate de facto on uncompensated marginal excess reserves. (This particular interest rate aspect of monetary operations should have become even more evident to monetarists by recent arrangements in countries like Japan, where a negative interest rate must be paid on the most marginal tier of excess reserves, in order to implement a negative interest rate policy, notwithstanding the “sheltering” of a core excess reserve position at a zero interest rate.)

    In other words, it is IMPOSSIBLE to have a corresponding net (i.e. “unreversed”) monetary expansion – at least according to your own specification of the corresponding set of “possible”, “reversing” actions. One or more of those actions is in fact ESSENTIAL, not “possible”, in order to implement a non-zero target interest rate policy. For the monetary authority not to take any such action in reaction to FX purchases (one of which is the sale of other central bank assets) means that the banking system will force the short term policy rate to zero – due to the additional quantity of uncompensated excess reserves created by FX purchases, and the resulting arbitrage sequence set in motion by the commercial banks. That result is only valid under the unrealistic and unreasonable assumption that the monetary authority actually wants to target the short term policy rate permanently at zero.

  12. 12 Tom Brown March 1, 2016 at 9:59 am

    O/T: David, you’re probably already aware, but in case you weren’t, you get a “thank you” up front at the start of Jason’s slide deck that he’ll be presenting this summer (for your suggestion about Gary Becker). IMO, they’re looking pretty good. Enjoy.

  13. 13 David Glasner March 7, 2016 at 4:29 pm

    JKH, I am sorry, but I remain completely perplexed by what it is you are saying. Are you saying that it is not possible for a country to depreciate its currency by using new issues of its currency to buy up a foreign currency? Just because it creates excess reserves does not mean that bank lending rates goes to zero. The market for reserves may be re-equilibrated at a reduced, but still positive, rate and the resulting increase in prices and incomes will cause the demand for reserves to increase, gradually absorbing the excess over time until the bank’s lending rate recovers from the initial reduction.

  14. 14 David Glasner March 7, 2016 at 4:29 pm

    Tom, Thanks for the heads up.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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