Kasa: Understanding Trends in Foreign Exchange Rates

Basket of Goods. (Foreign Exchange Rates)

Kenneth Kasa’s article titled “Understanding Trends in Foreign Exchange Rates” tries to argue against the claim that the field of economics fundamentally cannot predict trends in foreign exchange rates. Countering Meese & Rogoff’s work on the subject, Kasa attempts to make the case that inflation and productivity growth can inform long-term trends in foreign exchange rates.

The focus of the article shifts to the history of the Bretton Woods system, a post World War 2 attempt by the Western powers to rebuild the global financial system. Kasa explains that one key advantage the system had was its effect on a country’s ability to manipulate its currency in desperate aims to undercut other states to attract employment, which was going on at the time and likely contributing to a destabilizing political climate.

What the Bretton Woods system did was peg the U.S. dollar to the gold standard. From here, each other country’s currency foreign exchange rate became fixed to the dollar. And so, to the victor (and financier) go the spoils: the U.S. dollar was now the global store of value.

One key disadvantage highlighted by Kasa is that having a finite stock backing an ever-inflating amount of dollars had the potential for—and did—create a run on confidence in holding USD as the value of the currency continued to trend lower. This inflation proved to be fundamentally unsustainable.

With Nixon announcing the collapse of the system in 1971, economists who lobbied for, and welcomed, the system’s demise did not predict how volatile international exchange rates would be. In the post-Bretton Woods era, the article stresses that real exchange markets are characterized in two ways: extreme volatility of rates, and a general long-term trend against the U.S. dollar.

Kasa claims two theories can explain this long-term trend: Purchase Price Parity theory for nominal foreign exchange rates and the Balassa-Samuelson theory for real foreign exchange rates.

Using Japanese and German exchange rate and relative price level data concerning the dollar, Kasa shows that while short-term (year-to-year) fluctuations exhibit random behaviour, there seems to be some correlation with price levels on a long-term outlook.

The Balassa-Samuelson theory attempts to explain the difference between relative purchase price parity levels and the exchange rate (also on a long-term scale). This theory considers the role of international pricing mechanisms that traded goods exhibit in the face of rising productivity in those sectors. Ultimately, it predicts that productivity growth drives wage increases in traded goods sectors, which spills over into non-traded goods sectors. This spill-over price increasing effect is propagated throughout the economy and results in higher prices overall.

Ultimately, neither of these theories can explain the short-run variation in exchange rates nor their volatility. What Kasa stresses is that if one makes their lens decades-wide (meaning extremely long-term), inflation differentials (PPP) and productivity growth differences, as explained by Balassa & Samuelson, can indeed inform exchange rate trends.

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