In my recent book entitled Alternative approaches to monetary policyI described two different monetary policy measures at low interest rates, an expansionary and a contractionary policy:
Because of the interest parity condition, we know that these are both low interest rate policies. International investors will accept lower interest rates on safe assets located in countries where the currency is expected to appreciate over time.
And yet the American example (often called overshooting) is an expansionary monetary policy, leading to a weaker currency in the long run, while the Swiss example is a contractionary policy, with a stronger franc in the long run. If we reason backwards, we cannot assume anything about the direction of monetary policy simply by looking at the change in interest rates. Both countries had lower nominal interest rates, but one policy shock was expansionary while the other was contractionary.
Interest rates are not monetary policy!
In a recent post, John Cochrane presents a very similar example, but with a different framework. His chart shows two cases of higher interest rates (currencies expected to appreciate), but note that he also presents both expansionary and contractionary monetary shocks:
Here’s how Cochrane explains the graph:
The image shows the possibilities. Suppose interest rates rise for three periods, as shown. What happens to the exchange rate? Well, a higher interest rate at t must imply an expected depreciation from t to t+1, so there must be three periods of depreciation while the interest rate differential persists. The solid red line shows that possibility. Once interest rates return to normal, the exchange rate stops moving, but at a permanently lower level. (The exchange rate is a difference in price levels and therefore continues to fall as long as inflation is higher.)
But as before, the international Fisher equation is not a complete model in itself. It does not say what happens to the exchange rate at time t. That rate can jump up or down. The dotted lines represent three options. The exchange rate could fall and then continue to fall. The exchange rate can rise sharply and then fall in value. Or the exchange rate could rise just enough so that the expected depreciation brings it back to its original level.
We’re back in the equilibrium selection quagmire of my last post. Standard models now add ingredients to find the equilibrium where the exchange rate returns to its previous level. So the standard answer: Why do higher interest rates increase the exchange rate? Well, higher interest rates cause a decline in value. But the exchange rate jumps up first, so it can now depreciate back to its original level.
But why would the exchange rate return to its previous level? That is the Achilles heel of this story. There is no natural force that brings down nominal exchange rates. Since the exchange rate is a relationship between price levels, we need to think about what the nominal anchor on the price level is.
There are obviously a lot of similarities between what John does and what I did. We are both heterodox economists, who are critical of the Standard Model. But there is also an important difference. My conclusion is that it is simply wrong to talk about monetary policy in terms of interest rates – that this is the misconception of reasoning from a price change.
Cochrane believes that we should think about monetary policy in terms of interest rates because that’s how it works in the real world. But he sees the problem, which he sees as a kind of indeterminacy, or a matter of “multiple equilibrium.” His search for a solution, a way to determine which path is the real path, led him to the ‘Fiscal Theory of the Price Level’:
The bottom line: The standard view of how interest rates affect exchange rates suffers from many of the same problems as the standard view of how interest rates affect inflation. This is great news for young researchers. The most fundamental policy exercise of all in international economics is up for grabs. I am hopeful that fiscal theory will finally solve the gaping hole in multiple equilibrium, and that we will make great progress if we treat inflation and exchange rates together as joint policy outcomes.
I prefer to lock things in by focusing on the market forecast of NGDP growth, perhaps using forward contracts.
It would be good to have John on the monetarist market team. He has much better technical and writing skills than I do, and would immediately become the leader of this little school of thought. Unfortunately, he is a bit allergic to the monetarist approach. We will have to content ourselves with having a powerful ally in our criticism of the standard model, even if he promotes another alternative model.
On my new blog I have one related post for those who want to delve deeper into the subject.