A new mind-set for exchange rates
If we accept that the market price for currency exchange does not always gravitate towards an equilibrium rate, as assumed by free market adherents, this paper asks what level of intervention is needed.
If we accept that the market price for currency exchange is not always gravitating towards an equilibrium rate, the policy mind-set can and should shift fundamentally, to focus on two questions. What is the equilibrium rate? Can intervention shift the actual rate towards this?
The first question poses a major challenge for policymakers. While a free-float regime does not require the policymakers to have any view at all as to the ‘right’ exchange rate, the new mind-set requires them to have a view on the equilibrium exchange rate. This is not easy (perhaps impossible) to do with precision, but the answer might well be in the form of a range reflecting the array of ‘rational beliefs’ (just as inflation targeting sees the acceptable inflation rate as a band rather than a single point).
The second question requires a similar shift in policy mind-set. Instead of assuming that the market has established the equilibrium rate (and therefore any intervention will take the actual rate away from its equilibrium), if the market rate is sub-optimal, this opens the possibility that successful intervention would take the rate towards equilibrium. Then the policy question is an operational one: does the policymaker have the means to shift the rate in the right direction?
Agenda is the quarterly journal of the ANU College of Business and Economics. Launched in 1994, Agenda provides a forum for debate on public policy, mainly (but not exclusively) in Australia and New Zealand. It deals largely with economic issues but gives space to social and legal policy and also to the moral and philosophical foundations and implications of policy.
Stephen Grenville is a Lowy Institute Visiting Fellow.