Home > Causes of Inflation, Dollar, Theory > Grab the Reins on the Dollar, Part 2

Grab the Reins on the Dollar, Part 2


I hadn’t meant to do a ‘part 2’ on the dollar, but I wanted to clear something up.

Some comments on yesterday’s article have suggested that a strong dollar is a global deflationary event, and vice-versa. But this is incorrect.

The global level of prices is determined by the amount of money, globally, compared to global GDP. But the movements of currencies will determine how that inflation or deflation is divvied up. Let us look at a simplified (economist-style) example; I apologize in advance to those who get college flashbacks when reading this.

Consider a world in which there are two countries of interest: country “Responsible” (R), and country “Irresponsible” (I). They have different currencies, r in country R and i in country I (the currencies will be boldface, lowercase).

Country R and I both produce widgets, which retail in country R for 10 r and in country I for 10 i. Suppose that R and I both produce 10 widgets per year, and that represents the total global supply of widgets. In this first year, the money supply is 1000r, and 1000i. The exchange rate is 1:1 of r for i.

In year two, country I decides to address its serious debt issues by printing lots of i. That country triples its money supply. FX traders respond by weakening the i currency so that the exchange rate is now 1:2 of r to i.

What happens to the price of widgets? Well, consumers in country R are still willing to pay 10 r. But consumers in country I find they have (on average) three times as much money in their wallets, so they would be willing to pay 30 i for a widget (or, equivalently, 15 r). Widget manufacturers in country R find they can raise their prices from 10 r, while widget manufacturers in country I find they need to lower their price from 30 i in order to be competitive with widget manufacturers in R. Perhaps the price in R ends up at 26r, and 13i in I (and notice that at this price, it doesn’t matter if you buy a widget in country R, or exchange your currency at 1:2 and buy the widget in country I).

Now, what has happened to prices? The increase in global money supply – in this case, caused exclusively by country Ihas caused the price of widgets everywhere to rise. Prices are up 30% in country R, and by 160% in country I. But this division is entirely due to the fact that the currency exchange rate did not fully reflect the increased money supply in country I. If it had, then the exchange rate would have gone to 1:3, and prices would have gone up 0% in country R and 200% in country I. If the exchange rate had overreacted, and gone to 1:4, then the price of a widget in country R would have likely fallen while it would have risen even further in country I.

No matter how you slice it, though – no matter how extreme or how placid the currency movements are, the total amount of currency exchanged for widgets went up (that is, there was inflation in the price of widgets in terms of the average global price paid – or if you like, the average price in some third, independent currency). Depending on the exchange rate fluctuations, country R might see deflation, stable prices, or inflation; technically, that is also true of country I although it is far more likely that, since there is a lot more i in circulation, country I saw inflation. But overall, the “global” price of a widget has risen. More money means higher prices. Period.

In short, currency movements don’t determine the size of the cake. They merely cut the cake.

In a fully efficient market, the currency movement would fully offset the relative scarcity or plenty of a currency, so that only domestic monetary policy would matter to domestic prices. In practice, currency markets do a pretty decent job but they don’t exactly discount the relative changes in currency supplies. But as a first approximation, MV≡PQ in one’s own home currency is not a bad way to understand the movements in prices.

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  1. Eric
    June 2, 2015 at 7:29 pm

    “No matter how you slice it, though – no matter how extreme or how placid the currency movements are, the total amount of currency exchanged for widgets went up (that is, there was inflation in the price of widgets in terms of the average global price paid – or if you like, the average price in some third, independent currency).”

    I don’t understand how you’ve shown this. In fact, I don’t understand what you mean by “the total amount of currency.” You picked a case where the exchange rate doesnt fully reflect the inflation, so in that one, its easy, the prices go up in both currencies. But in the case where the exchange rate overshoots, and the price goes down in rs and up in is, how do we measure the “total amount of currency exchange for widgets”? The only thing you suggest is that we measure this in some third “independent” currency. But what is that? If its a “responsible country” then its currency will stay on par with the r, and the total price in inds will go down.

    • June 2, 2015 at 8:37 pm

      Well, you’ve found a flaw in my example, to be sure. I have to think about it a bit, but I suppose the problem is that I am holding production constant. In the case where the FX overshoots, so that the price in r goes to (say) 8 and the price in i goes to 50, then what would actually happen is that country I would produce more and country R would produce less (unless all costs of production happened to deflate as well). Which is also what happens when a currency weakens, right? Production goes up in the country with cheaper currency and down in the country with stronger currency. So you’re right about my example, but the flaw is in my example – too simple – not in the underlying truism.

      • Eric
        June 3, 2015 at 10:54 am

        I guess I still dont see how that helps the example. Sure, if the price of widgets imported from I goes down in R, and the widget makers in R have to cut their prices to compete, then production of widgets in R will go down, and up in I. But I still dont see how one gets an objective notion of “the total amount of currency spent on widgets”. If you measure the amount of currency in “i”s, its up, if you measure it in “r”s, its down. There’s no third “independent” currency. or at least I’m missing something if there is.

      • June 3, 2015 at 11:52 am

        You’re right, it doesn’t really make sense to talk of a mythical fixed currency. My example doesn’t really capture the basic facts of the matter, that adding money raises all prices before the currency movements divvy up the effects. I need a better example. The intuition is simply that a currency increase from one side’s perspective is exactly offset by a currency decrease from the other side, so it can’t possibly do anything other than cut the cake. It can’t change the size of the cake. But this example doesn’t show that.

  2. Eric
    June 3, 2015 at 1:07 pm

    If there’s no mythical fixed currency, then I don’t see how there’s a cake to be divyed up. (sp?)

    I understand what you are getting at: I has created inflation for itself, and depending on currency movements, it can send some of that to R, keep it all, or even get more while R gets some deflation. Its a clear qualitative notion. But there’s no conserved quantity because there’s no objective unit in which to measure it. You can express the idea you want qualitatively, but I dont think there’s a concept for expressing it quantitatively, nor am I sure there is such a thing as “the global level of prices.” Sure, you could create some kind of trade-weighted currency index, but that would beg all sorts of questions.

    “The intuition is simply that a currency increase from one side’s perspective is exactly offset by a currency decrease from the other side”

    IOW, I agree with the above except for the word “exactly”. it needs to be replaced with “qualitatively”.

  3. Eric
    June 3, 2015 at 1:17 pm

    I went over to SA to read the comments you were addressing, and I think I can make my point in a way that helps the first commenter a little bit (but probably not completely):

    how you measure the “global level of prices” depends entirely on your reference currency. If you happen, for whatever reason–that Im not defending–to believe that the $ is the appropriate reference currency (maybe because you think its the currency in which most debts are denominated) then you might believe that a rising dollar is a creator of global deflation.

    • June 3, 2015 at 2:04 pm

      I think the only way you can claim that is if the rising dollar is rising completely irrespective of any change in currency quantities. If all currency quantities are fixed, then in principle that can work. But if it is rising because everyone tripled their currency supply but the US only doubled it, then it’s madness to say the US dollar gain is deflationary.

  4. Eric
    June 3, 2015 at 3:04 pm

    agreed. and yet the commodity and precious metals pits seem to disagree. though european bond traders are being to come around to your view.

    • June 3, 2015 at 4:11 pm

      I have NO idea what THOSE guys are thinking about. I haven’t understood it for at least four years!!

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