Given the rising pressure for the Reserve Bank to target the currency as well as other things in New Zealand it is important to have a look at reasons why people may think our currency is misaligned. I have said before that IF the currency is overvalued I think it is a structural issue and is really unrelated to monetary policy – however, there are of course many other arguments.
We have mentioned the begger thy neighbour type externalities from domestic focused monetary policy – something that a small country like NZ cannot cause, and so we can’t blame our domestic monetary environment for.
And a new discussion paper by the Dallas Fed discusses why the exchange rate may be an important issue to look at intervening into (ht Econobrowser). Specifically the paper states:
If the nominal exchange rate regime matters for the determination of relative prices such as the real exchange rate or the terms of trade, it must matter because there is some kind of nominal price stickiness. For example, if the U.S. dollar/euro exchange rate is to affect any real prices, it must be because there are some nominal prices that are sticky in dollar terms and others that are sticky in euros. From the standpoint of modern macroeconomics, the question should be posed: What policy best deals with the distortions from sticky prices and other sources? Is it a fully flexible exchange rate, or some sort of exchange rate targeting?
However, coming back to New Zealand I still feel fully flexible exchange rates are appropriate. Why? Apart from the fact that I view such a “relative price shock” as an insufficient condition for intervention, the idea of price stickiness only matters when export prices are SET by exporters. New Zealand is a small open economy that sells on foreign markets and receives (and pays) the world price – therefore our trade prices are flexible.
The inefficiency occurs when prices are denominated in domestic dollars, and do not change in the face of some “shock” which changes the value of the exchange rate.
Finally there is an asset price bubble argument for intervention (as the currency is a forward looking asset price). Whether we can really identify and then improve welfare by intervening against “currency bubbles” is highly debatable – and it is an area the Bank has already been involved in (by becoming a currency trader 😉 )