The currency market – small menu costs matter
Posted May 26, 2008on:
Immediately following the release of the overseas merchandise trade data today the dollar slumped by about 20 basis points, however it didn’t stay down for long, more than recovering from this low point:
You might wonder why this fall and rise is even interesting – but the reasons behind it imply that issues such as “menu costs” can be important. Why? Well the headline number of today’s result provided a bad headline (monthly trade deficit biggest in 26 years!), but for a small time investment (reading the Statistics New Zealand news release) it would become obvious that the headline number was deceiving and in fact today’s result was relatively positive (as a significant proportion of the additional import activity was the result of one-off capital imports for further oil production).
The menu cost mattered in this case as the opportunity cost associated with time it would require to read the release was high – if a bad headline comes out it is in the dealers interest to react before everyone else! As a result, a situation like this truly does have a substantial menu cost (which results from the first-mover advantage implicit in the situation) even though, on the face of it, it would initially seem difficult to view spending a minute reading a free release as a significant cost!
Why does all this matter. Well menu costs can be the basis of price rigidity (although I doubt this in the case of currency trading) and also can be the basis of what we may view as “irrational” behaviour in the marketplace. If small information asymmetries can have such a large impact on the behaviour of agents, and the equilibrium price, it dilutes the power of the price as an efficient signal to allocate resources. This does not mean we should give up on prices – it merely shows us the importance of the provision of information in the economy.