On Rising Price and Declining Value

This work draws substantially from M Pettis.

The price of a currency is driven by several factors:

Inflation Differential: If inflation of country A is below country B, then the currency of country A will have depreciated in real terms.

The kind of Inflation matters. We cannot just assume that the difference in CPI between two countries is an effective metric of the inflation differential. What really matters is the inflation in the cost of tradable goods sector.

Productivity: Wage growth relative to productivity growth affects the real exchange rate. Why? Because ...If productivity growth in country A exceeds productivity growth in country B, and that differential is not offset by wage growth differential, that has the effect of depreciating currency A. Low wage growth relative to productivity is effectively a tax on consumption.

Again - the kind of productivity matters. Tradable Goods.

Cost of Capital: The cost of capital is an important input in production of tradable goods. If country A subsidizes cost of capital relative to country B, it is the same as an import tariff or export subsidy. In either case, the effect is to reduce the real exchange rate of country A.

Other Subsidies: Any other differential in the growth rate of subsidies, including taxes will have the effect of real appreciation of depreciation. Subsidized land, taxes, energy.

So What Next: An undervalued real exchange rate is the same thing as a consumption tax on imports which effectively subsidizes manufacturers in the tradable goods sector. It reduces household income, household consumption, and increases production and the trade gap.

Anytime household consumers are explicitly or implicitly taxed and the proceeds are directly or indirectly used to subsidize manufacturers in tradable goods (example: forcing household depositors to lend to manufacturers at artificially low rates) it is the same thing as a real depreciation in the currency.

Any policy that forces up savings rate (production in excess of consumption) or forces down the consumption rate will lead to trade balances.

In that sense, it is very possible to have the nominal price of a currency going up, while at the same time, differential in subsidies to capital, productivity, and inflation could actually depreciate the real value.