Would a fixed exchange rate save NZ?
Posted April 9, 2008on:
According to the Standard, having a free floating exchange rate puts New Zealand at the mercy of speculators – I take this to mean that the author would prefer New Zealand having a fixed (or at least semi-fixed) exchange rate.
What does having a fixed exchange rate mean? Well, if we have a fixed exchange rate we are setting the value of our dollar compared to the value of other countries currencies. In this case, we have certainty about the future export and import price of goods – which is a good thing.
However, in this case our currency is just as open to currency speculation (if not more so, as the price of the currency is fixed, making yield focused attacks more of a “sure thing”), implying that this perceived benefit does not exist – it merely moves on to influence another economic variables. In fact what it does (as long as we don’t close the country off to all capital markets) is removes New Zealand’s ability to control its interest rate (as the government has to print money at a level required to keep the exchange rate fixed) . In economics this is termed the impossible trinity.
Without the ability to control interest rates, we also lose our ability to stabilise prices – thereby implying that the domestic price of goods will become more volatile, and inflation expectations are likely to become unanchored.
We then have to ask, for New Zealand what is more important, price stability or exchange rate stability? New Zealand is an open economy so the exchange rate is important. However, the fact that firms can hedge against changes in the exchange rate more effectively than households can hedge against changes in the rate of price growth implies that stabilising growth in the price level and anchoring inflation expectations is more important for the nation.
The author also states that:
we could keep the exchange rate lower, which would deliver far greater increases in export earnings than even the China FTA
I hope he realises that keeping the exchange rate artificially low will benefit exporters but at a cost to New Zealand households. Although such a policy may make sense in the case where we have “infant industries” in the export sector, I think it is inappropriate in New Zealand’s case (given that our industries that have a comparative advantage with the rest of the world are already highly developed).
As a result, fixing the exchange rate artificially low will make New Zealand households poorer, and ensure that these households have to face high levels of volatility in the price level (with an upward trend as doing so involves printing “extra money“, which is likely to dis-proportionally hurt the poor) – a surprising policy recommendation from a left-wing blog.