March 25, 2010
A Still Relevant GAO Classic: Floating Exchange Rates in an Interdependent World and "Overvaluation"
Following up on my misalignment post from Tuesday, here's a volume compiled by the GAO when it was the General Accounting Office containing a symposium on exchange rates. The symposium took place in the midst of currency overvaluation: "Floating Exchange Rates in an Interdependent World". The authors included Richard Cooper, Stanley Black, Rudiger Dornbusch, Jeffrey Frankel, and Jacob Frenkel.
Of particular interest is Jeffrey Frankel's "The 1980-83 Dollar and Six Possible Meanings of Overvaluation" (p. 90 onward).
This paper considers six possible, very distinct, definitions of the words "overvaluatlon" and "undervaluation," or the equivalently ambiguous term "disequilibrium."
First, the words could refer to a situation in which the exchange rate is at a level at which the supply of foreign exchange does not equal the demand. This possibility, nonclearing of financial markets, is dismissed out of hand in light of the very low levels of transactions costs, capital controls and other barriers to portfolio ad'justment among most of the major industrialized countries.
Second, overvaluation of a currency could mean that its private supply exceeds its private demand: i.e., that there is foreiqn exchange intervention by one or more central banks to support the value of the currency at a level higher than it would be in a completely free market.
Third, overvaluation could be used to describe a currency that has a higher value than that dictated by long-term fundamentals but that is determined by short-term fundamentals, such as the real interest rate or the current account surplus. This is the phenomenon of overshootinq and is discussed in section III. Fourth, overvaluation could mean that one can, in expectation, make money by selling the currency forward. This is the possibility of irrational expections discussed in section IV.
Fifth, overvaluation could mean that, even though expectations are rational, the exchange rate nevertheless diverges from the equilibrium determined by fundamentals, short-run as well as long-run, This is the possibility of speculative bubbles discussed in section V.
Sixth, overvaluation could pertain to the real effects of the exchange rate, rather than its determinants. Under this interpretation the loss in competitiveness by the export and import-competing industries is undesirable, or the reverse effects on the corresponding industries in foreign countries are undesirable for them. The possibility of undesirable welfare effects is addressed in section VI.
A later version of the article is available as "Six Possible Meanings of 'Overvaluation': The 1981-85 Dollar," Essays in International Finance No. 159, International Finance Section, Princeton University: Princeton, December 1985.
Posted by Menzie Chinn at March 25, 2010 12:00 PMdigg this | reddit
"Scond, overvaluation of a currency could mean that its private supply exceeds its private demand: i.e., that there is foreiqn exchange intervention by one or more central banks to support the value of the currency at a level higher than it would be in a completely free market."
This is the one at issue. As for evaluating the effects of an over-(or under)-valuation, I would agree with Krugman that the best indicator is the amount of intervention. This gives the best picture as to what effect the artificially-encouraged local consumption (saving) is having on the AD and on CA balances in the rest of the world.
Posted by: don at March 25, 2010 02:15 PM
I have to confess I've never heard of this paper. A cursory inspection leads me to opine that the sixth "meaning" is the most important. This is also very relevant to the literature review I'm working on right now. Thanks.
Posted by: Mark A. Sadowski at March 25, 2010 03:50 PM
Very interesting post. Thank you.
Posted by: Steve Kopits at March 25, 2010 08:52 PM