The Fed, the Exchange Rate, and Gas Prices

Critics are blaming the Fed for high gasoline prices. The argument is that quantitative easing has caused the dollar's exchange rate to fall, and so imported goods, like crude oil, are more expensive. The higher crude oil prices are passed on in higher gasoline prices.

There is an element of truth to this argument.

Suppose the economy begins in equilibrium, and as a bolt from the blue, the Fed decides to increase the quantity of money. This creates an excess supply of money. What is the market process that causes the real quantity of money to adjust to the demand to hold real money balances?

How does the Fed expand the quantity of money? The usual approach is an open market purchase of government bonds. Since the Fed is purchasing bonds, the direct and immediate effect is an increase in the price of the bonds and a decrease in their yield. The "interest rate" decreases. (Of course, it is possible that expectations of the impact of the increase in the quantity of money might cause others to sell more bonds than the Fed buys. Interest rates could conceivably rise. Still, a lower short term interest rate is plausible enough and, frankly, is the most plausible explantion of how central banks target short term interest rates.)

Assuming the interest rate paid on money itself does not adjust instantly (perhaps because it is fixed at zero for hand-to-hand currency,) the lower interest rate reduces the opportunity cost of holding money, and so raises the real demand for money to match the new, increased quantity of money.

However, in an open economy, the reduction of domestic interest rates creates an incentive for domestic investors to purchase foreign bonds instead of domestic bonds and for foreign investors to do the same. Domestic investors sell dollars for for foreign currencies and foreign investors buy fewer dollars with foreign currencies. The increase in the demand and decrease in the supply of foreign currencies raises their dollar prices. And this is a decrease in the exchange rate of the dollar.

Note that this element of the interest-elasticity of the demand for dollar denominated bonds--a shift from dollar-denominated bonds into foreign bonds--dampens the impact of the open market purchase on interest rates. In the limit, the demand for domestic bonds could be prefectly elastic with regards to the domestic interest rate, and so, there would be no impact on dometic interest rates and instead only a decrease in the exchange rate.

The decrease in the exchange rate of the dollar should result in an increase in the prices of imported goods. To the degree imported goods have prices set in terms of some other currency, and those prices are sticky, then the increase in the prices of imported goods is proportional and automatic. For a small economy, whose demand and supply of the imported goods is small relative to the market, and where prices are likely to be quoted in foreign currencies, the effect is much the same. (For crude oil, none of these conditions hold for the U.S. The price is quoted in dollars, is flexible, and U.S. demand for oil is a significant part of world demand.)

Assuming the conditions hold for a decrease in the exchange rate to result in higher import prices, then other things being equal, this increases the price level, and involves increased inflation as the price level moves to a higher growth path. The higher price level reduces the real quantity of money, bringing it into equilibrium with the demand to hold money.

However, the increased prices of imported goods will raise the demands for import-competing goods. Further, the decrease in the exchange rate reduces the prices of exported goods to foreign purchasers. This increases the demands for those goods at a given dollar price. And so, the decrease in the exchange rate raises the demands for domestically-produced output.

For this thought experiment, the economy started in equilibrium, which would include the real demand for currently-produced output being equal to the productive capacity of the economy. If that is true, then an increase in the demand for the products of import competing industries and exported goods should result in shortages of goods and so higher prices of the goods and the resources needed to produce them, including labor.

However, it is likely that firms will expand production and employment temporarily in response to an increase in demand--causing output to raise above potential and the unemployment rate to fall below the natural unemployment rate.

The higher prices of both export and import competing products, combined with the higher prices of imported goods, combine to reduce the real quantity of money, returning to its intial level. Any temporary increase in aggregate output implies an increase in real income. Assuming money is a normal good, that raises the demand for money.

However, these increases in output are temporary, and more or less by definition, firms will raise prices enough so that the real demand for output returns to productive capacity. As the dollar prices of import competing goods rise, no longer are they bargains relative to imports, and so their real demands fall again. As the dollar prices of exports rise, no longer are they bargains for foreigners, and so their real demands fall.

Once the price level rises enough for the real quantity of money to fall back to the demand real money balances, any remaining decrease in interest rates is reversed, and real expenditures on imports and exports return to their initial values. However, the exchange rate remains lower, because the prices of domestically produced goods, including both exports and import competing goods, are higher.

This is a pretty simple analysis, but it does cause reason to believe that a bolt from the blue increase in the quantity of money would tend to cause the exchange rate to drop and result in a higher prices of imported goods, and so a higher price level, and so a higher infation rate for a time. The prices of other goods and services will sooner or later catch up. In the end, the result is simply a higher price level (or growth path of prices.) The real exchange rate, real imports, and real exports are not effected in the long run. Nor are real interest rates, real output, or employment. The price level is higher and the nominal exchange rate is lower.

However, there are plenty of other scenarios that would result in a lower exchange rate, an increase in the prices of imported goods, and so a higher price level. For example, a decrease in the demand for investment and an increase in the supply of saving. A decrease in the demand for investment means domestic firms are purchasing fewer capital goods at an given real interest rate. An increase in the supply of saving is a reduction in the demand for consumer goods at any given real interest rate.

These reduce the natural interest rate. As before, this creates an incentive for domestic investors to purchase fewer domestic bonds and more foreign bonds. Similarly, there is less incentive for foreign investors to purchase dollar-denominated bonds. Again, as before, the increase demand for foreign exchange and decrease in the supply results in increased prices for foreign currencies. The dollar falls in value. And, as before, this effect reduces the impact of the change in saving and investment on the domestic (natural) interest rate.

As before, the lower exchange rate raises the prices of imported goods. And the increase in the prices of imported goods raises the demand for import competing goods. And, as before, the lower exchange rate raises the demand for exports. Just as before, there is an increase in the demand for output.

However, in this situation, these added demands for output are offset by the initial decrease in the demand for investment and incease in the supply of saving. That is a decrease in the demand for capital goods by domestic firms and a decrease the demand for consumer goods by domestic household.

If no imbalance between the quantity of money and the demand to hold money develops, then the result is a complete offset, with expenditures on domestically produced output remaining unchanged. Spending on consumer goods falls, but spending on domestically produced consumer goods remains unchanged or even rises. Spending on capital goods by domestic firms falls, but spending by foreigners on capital goods may fully offset that change.

To the degree that interest rates do change and the interest rate on money doesn't change, this process would result in an increase in the demand to hold money. And, of course, it is possible, that an increase in the demand to hold money happens to occur at the same time.

For example, suppose the President of the U.S. says that another Great Depression is eminent if certain legislation doesn't pass. Opponents doubt that the legislation will help. It fails at first, then finally passes. Polling shows that a majority of Americans believe that another Great Depression is likely or very likely. There is simultaenously an increase in the demand for money, an increase in the supply of saving, and a decrease in the demand for investment.

The equilibration of the change in saving and investment includes a lower exchange rate, higher import prices, and an expansion of the demands for both exports and import-competing goods. Presumably, it also involves a lower interest rate, which should dampen the decrease in investment demand and increase in saving supply.

If the Fed targets interest rates, then if the natural interest rate falls, the Fed needs to lower market interest rates. Trying to keep market interest rates pegged above the natural interest rate leads to a deflationary black hole.

If the Fed is targeting the quantity of money, it could just ignore all of this. Eventually, the prices of domestically produced goods and services, and resources such as wages, will fall enough so that the real quantity of money will rise to match the demand. The real interest rate will fall to the new natural interest rate as will the real exchange rate. The relative prices of imports will rise and import competing and export industries will expand as before.

Unfortunately, until prices and wages make the necessary adjustment, real output will remain below capacity and there will be unnecessarily large levels of unemployement of labor and other resources.

And finally, if the Fed chooses to target the exchange rate because the lower exhange rate causes higher import prices and so a higher price level, then the Fed will have to contract the quantity of money (or if the demand for money is already rising, just fail to expand it enough) and as above, prices and wages will eventually move down to a lower growth path, and real interest rates and the real exchange rate will fall. The relative prices of imports will be higher and import competing and export industries will expand.

Now, which sort of scenario is more likely? Did the Fed just expand the quantity of money as a bolt from the blue? Or have there been some changes in the fundamentals--the real demand for money, the supply of saving, and the demand for investment?

For me, the answer is simple. Money expenditures on domestic output remain well below the trend of the Great Moderation. The Fed's monetary policy of the last few years isn't a bolt from the blue hitting an economy in equilibrium. Rather, it has been too little and too late.

What the Fed should do is target a growth path for GDP, and let the quantity of money, interest rates, and the exchange rate change however much is needed to clear markets. Targeting interest rates, the exchange rate, the GDP deflator (the prices of domestically-produced goods) or the CPI (which includes imports) are all wrongheaded.