More on exchange rate targeting

Now in the short term a look at the exchange rate is important for a monetary authority – as it is part of the “inflation targeting” framework.  This is because a stronger dollar implies a lower prices level, which may in turn influence expectations of inflation or the credibility of the central bank to maintain a level of price growth.

However, in a wider context the RBNZ has implied, and BERL has stated, that there is some role for exchange rate management.  Although I do not agree, some recent academic work has come down on their side (ht Econbrowser).

In the paper they say that an increase in home interest rates (in certain circumstances eg a future increase in productivity) can lead to “excessive consumption” at home relative to what we should experience.  Driving this is:

  1. Incomplete markets (required) and sticky export prices (not required but welfare relevant),
  2. Leading to a negative “wealth effect” on our trading partners,
  3. Leading to a suboptimal adjustment in rates (interest rates, and thereby exchange rates) overseas,
  4. Leading to the “wrong” allocation of consumption goods between countries

Although this is the case, I am not sure how relevant it is in the NZ situation.  We are a small portion of trade with our own trading partners, and so an increase in our consumption doesn’t really influence the level or price of consumption in other countries – we are a residual claimant.  As a result, the welfare loss for the “rest of the world” is virtually non-existant – there is no “negative spillover” (read negative externality from our monetary policy).

In this case we are left with the fact that we are a small open economy, and we face a world interest rate.  If there are medium term allocation issues it will be the result of foreign monetary policy, not our own.  And sadly we can’t do anything about that.