Britain and Sweden

Both Brad DeLong and Matt Yglesias are critical of this FT piece discussing Swedish and British stabilization policy:

Because Sweden has been living within its means it is one of the member states that has weathered the crisis best. In Britain, on the other hand, the new coalition government has inherited the largest budget deficit of any EU country.

They both point to the fact that Sweden has depreciated the kronor.  Let me say right up front that I don’t have any easy answers to the issues raised here.  But I do think they slightly oversimplify what’s going on.  First let me indicate where I agree:

1.  Both Britain and Sweden should avoid policies that contract aggregate demand.

2.  Part of Sweden’s relative success may be due to the fact that the kronor has depreciated against most currencies.

But here’s what DeLong and Yglesias seem to overlook.  The kronor has not depreciated against the British pound; this link shows the pound has depreciated slightly against the kronor (with some month to month variation.)  In other words, the British pound has depreciated against the dollar and euro even more sharply than the kronor has depreciated against the dollar and euro.  So it doesn’t really solve the mystery of why Sweden has done better than Britain, with far less fiscal stimulus, to simply point to the fact that the kronor has depreciated.

My hunch is that fiscal stimulus probably has less effect than its proponents believe.  But I would also admit that in the case of Britain my preferred solution ( monetary stimulus) also doesn’t seem to have been all that effective.  I haven’t had time to study the British situation, but my hunch is that the sort of real factors that Arnold Kling and Tyler Cowen discuss are relatively more important in Britain, as its economy is heavily dependent on the banks in the City of London.  But that’s just a guess based on the relatively high inflation rate in Britain.  In contrast, Sweden may do some of the same sort of machinery exporting to the developing countries that Germany does.  Or there may be other structural issues in Britain having to do with labor markets, VATs, etc, that I am unaware of.

If anyone has any useful information on the British situation, I’d appreciate hearing about it.  (I know one commenter did mention some data earlier, but I’m afraid I lose track of these things.)  I’d be interested in data on British NGDP, wage rates, inflation, and possible distortions in the inflation data.  I know that the UK government has grown dramatically as a share of GDP over the past 10 years, much more than can be explained by the recession.  It would also be interesting to compare the size of the UK government with the government in a country like Canada.  Why is the UK government so much larger, without apparently producing any better public services?  And thoughts?

PS.  I’m not saying that what DeLong and Yglesias wrote is incorrect, I just don’t think their comments resolve the issues raised by the quotation.  And DeLong’s Keynes quotation is a great one.



29 Responses to “Britain and Sweden”

  1. Gravatar of Jon Jon
    17. June 2010 at 12:58

    The expectation that future taxes will be higher.

  2. Gravatar of StatsGuy StatsGuy
    17. June 2010 at 13:28

    UK began the crisis with a huge negative trade balance, and an economy that was heavily weighted toward the finance sector. Sweden had the reverse:

    In the UK, it’s going to take a lot longer for the native industry to begin to take advantage of the lower currency, meanwhile they are going to need to endure some serious scarcity to bring their trade balance into line. The UK is a pretty strong case for taking national measures to retain core manufacturing industries (consider this an insurance policy) – the UK economy over time had shifted more towards a service economy with heavy focus on finance; in that sense, its financial sector benefit from a strong pound so long as its investments performed. The market saw this as profitable, robustness be d2mned.

    Think of it this way – the UK has a longer J-curve ahead of it, and if the sovereign continues to subsidize its import dependence, it will likely suffer a sovereign debt crisis. Expectations of default risk and inflation will cause further capital flight.

    UK needs to devalue and cut _imports_, which will likely require cutting sovereign expenditures for imports. If other countries complain about UK “beggar thy neighbor” devaluation, well, they can print more money too… which would stimulate demand for Brit goods.

    Everyone wants to be a creditor, however – and if everyone wants it, maybe there’s a reason why? Hmmm.

  3. Gravatar of marcus nunes marcus nunes
    17. June 2010 at 14:02

    Between 2002 and 2009, UK NGDP growth was 3.8% p.a and Sweden´s was 3.4%.
    Gov Exp in UK grew at rate of 4.2% p.a while in Sweden it was 3.4%. So G/Y in UK went up by almost 3% in 2002-2009 while it stayed constant in Sweden. In UK compensation to public sector employees went up by 6.1% p.a while in Sweden it increased by 3% p.a.

  4. Gravatar of marcus nunes marcus nunes
    17. June 2010 at 14:10

    G/Y UK:52%
    G/Y Canada: 40%

  5. Gravatar of StatsGuy StatsGuy
    17. June 2010 at 15:11

    As a followup to previous comment (in moderation), note unit labor costs in dollars in 2007:

    UK 147
    Sweden 76

    UK had lower output/productivity and similar wages/consumption. Having trouble finding very recent manufacturing as % of GDP data for sweden… Sweden has of course already benefited from a recent devaluation and govt. spending reduction.

  6. Gravatar of Doc Merlin Doc Merlin
    17. June 2010 at 16:24

    “Sweden has of course already benefited from a recent devaluation and govt. spending reduction.”
    I thought you were a neo-keynesian wrt government spending. My mistake.
    Also, the data you linked to makes sweden look very, very good. Very high manufacturing productivity and cheaper to hire.
    The UK on the other hand looks abysmal.

  7. Gravatar of tâtonnement tâtonnement
    17. June 2010 at 16:24

    But wouldn’t we expect a small open economy where exports account for 50% of GDP to benefit more from currency depreciation than a service based (76% of GDP) economy like the UK? Even if the pound fell more than the krona, it should have less of an impact since the primary beneficiary would be exports, of which the UK has few (oil is its number one export). Since 2008 to April 2010, the price index of UK imports also seems to be growing faster than the price index of exports, so we are still talking deteriorating terms of trade. Add to that the heavy bias to financial services in the UK economy and it’s not hard to see why it is struggling; the rising cost of imported goods is offsetting depreciation gains in export goods, whereas the services offered internationally are no longer in demand. No one seems to want to buy the services the UK is selling, even with cheaper pounds, and the cheaper pound has done nothing to persuade UK consumers to cut back on imported goods.

    Contrast that with Sweden, which has been able to take advantage of the boost a cheaper krona has given to export goods with demand for imports falling off as expected as consumers turn inward. Regardless, it may be premature to trumpet Swedish consumer sensibility, as they appear to have found their appetite for leverage now and are hard at work creating their own housing bubble.

  8. Gravatar of Indy Indy
    17. June 2010 at 17:20

    From 2008 high to 17-JUNE-2010, vs US Dollar:

    Swedish Krona: -23%
    Euro: -22%
    British Pound: -26%

    If anything – different results with nearly the same currency movements would seem to invalidate the “devaluation = success” theory, no?

  9. Gravatar of Doc Merlin Doc Merlin
    17. June 2010 at 18:05

    I am in complete agreement, I think a lot of economists confuse correlation with causation when it comes to currency devaluations.
    Examination of the USD price along with our current account deficit agrees with your observation as well. China has also increased the value of its currency quite a bit in the last few years, yet it still has massive export surpluses.

  10. Gravatar of William William
    17. June 2010 at 21:23

    “Swedish Krona: -23%” (Where are you getting this number?)

    Exports to the US are about 7%, Euro 31.3%, Norway 9.5%, Denmark 7.4%, UK 7.3%. Barely changed against the Euro, appreciated slightly against UK, slight depreciation against Denmark and Norway. Mostly unchanged, except for the 7% against the USD (with a little appreciation midway.) Ultimately a pretty small increase in exports relative to imports, but nothing major across the board.

    “Euro: -22%”

    Exports to US about 23%, Switzerland 7.6%, Russia 6.2%, China 5.5%. Devalued against all of these except for RUB, which it gained value against. Big picture: the EU went from a trade deficit to a surplus in 2008-2010.

    “British Pound: -26%”

    Exports to the US are about 14%. Germany 11.5%, Netherlands 7.8%, France 7.6%, Ireland 7.5%, Belgium 5.3%, Spain 4.1%. Thus, 44% to Euro countries. It has fallen against the Euro about the same as the USD. The trade deficit narrowed, as you would expect, but has nearly rebounded since.


    Swedish Krona: Mostly unchanged value, and mostly unchanged balance of trade
    Euro: Devalued almost across the board, balance of trade shifted towards increased exports
    British Pound: Devalued pretty strongly, balance of trade shifted towards increased exports, but has mostly regained 2008 form

  11. Gravatar of Lorenzo from Oz Lorenzo from Oz
    17. June 2010 at 23:19

    Scott: I think you should be impressed with the quality of your commenters.

  12. Gravatar of Econoclast Econoclast
    17. June 2010 at 23:57

    You asked about the UK. The statistical supplement to the OECD’s economic outlook has useful comparative data on the UK:,3381,en_2649_34109_1_119656_1_1_37443,00.html

    I would make the following observations about the UK’s performance over the past decade.

    1. Superficially, the UK performed well with relatively stable GDP growth and low and stable inflation. Partly, this reflected better policy (the Bank of England), but mainly it reflected a benign global environment.

    2. The UK was a big recipient of foreign capital. You might view the City of London as being one of the main intermediaries for global capital flows. The sharp rise in global capital flows boosted UK financial earnings. This pushed up sterling, held down interest rates, and further boosted the financial sector. This led to a form of ‘Dutch disease’. The success of the financial sector crowded out other private sector activity (especially manufacturing, which became much less competitive).

    3. For a Labour government, there was a dilemma. Intellectually, you don’t like bankers. But pragmatically, you can see these guys are boosting tax revenues. So, your response is: leave the bankers alone to make money, use the inflated tax revenues to redistribute to poorer parts of the UK (ie all of the bits away from London and the south east). Increased public spending helped to spread the wealth across the country. Without it, the UK would have looked even more lopsided with London becoming even more like Hong Kong or Monaco.

    4. The error was that the government thought the tax revenues from finance would be sustainable for ever. It spent on that basis (new hospitals, schools, huge increases in real wages for doctors etc).

    5. The private sector also believed that the growth of the financial system was sustainable as was the growth in the public sector. With low real interest rates and an upward revision to their long-run income expectations, households borrowed heavily to buy housing. The UK household sector has one of the highest debt-to-income ratios of anywhere in the world.

    6. Finally, the banking sector financed this increase in household indebtedness by borrowing in short-term wholesale markets. The deposit base of the banking system didn’t cover the lending. In effect, UK banks allowed UK households to borrow to ‘save’ by buying a house. (The government liked this because it boosted tax revenues again.)

    7. All of this made the UK uniquely vulnerable to the financial crisis. We built our economy on the assumption that the financial system would grow indefinitely. We used the revenues to finance growth in the public sector and to buy housing. We thought our long-run growth rate had risen and spent an increasing share of our national income. Now, we are realizing growth is going to be much lower and we have to save more out of slower-growing income. It will take years to work through this.

    8. But we do have our own currency, so we can devalue. And bond markets still believe in the credibility of UK institutions. So we are in a better position than many of our European neighbours.

  13. Gravatar of W le B W le B
    18. June 2010 at 03:15

    I recently supplied a link to Bank of England Money Supply figures for M4 and M4 Lending. Perhaps you were referring to those. The latest published June 7th for May are here:
    You also said you concentrated your attention on the Monetary Base.
    So here are May 2010 figures for UK M0
    Two days ago an announcement was made that regulatory powers were being transferred back to the Bank of England from the FSA.
    Thus the Governor of the Bk of Eng who kept money way too tight in 2007/early 2008 has been rewarded. Meanwhile he is repeating the same mistake in 2010.
    All the attention over here is on fiscal policy.
    The political //s with 1930/31 are uncanny. We await an emergency budget from Osborne as those in ’31 awaited one from Snowdon.
    As then both fiscal and monetary policy here are set to further reduce AD.

  14. Gravatar of StatsGuy StatsGuy
    18. June 2010 at 04:28

    tatonnement raises a good point about small/open economy – the devaluation quickly and directly affects a greater proportion of transactions.

    @Doc – I’m not against government spending, merely bad government spending. But I give the neo-keynesians this: the pure monetarist mechanisms for price level recovery depend heavily on the credit mechanism, and create short term opportunities for financial arbitrage within the finance sector which has large distributional consequences. This gives the financial industry a lot of political power. Monetarists need to think more about how/where money enters/leaves the economy – the fact that it enters without requiring govt spending doesn’t necessarily mean it enters in a manner that does not cause distortions.

    In other words – monetary injections caused by a high nominal yield curve by giving banks preferential access to short term credit are a massive subsidy to banks.

    In terms of efficacy, let’s say this: if the fiscal authority is cutting spending, the neo-keynesians argue that the pure monetary mechanisms may just end up with people loading up on reserves unless they can close the credibility gap regarding long term money supply expectations. If the monetary authority is shrinking the money supply, the neo-monetarists argue that fiscal debt-financed spending is countered by expectations of future debt repayment. But EVERYONE should agree that if the monetary authority prints money and the fiscal authority spends it, the price levels MUST go up, and fairly quickly.

  15. Gravatar of Indy Indy
    18. June 2010 at 04:55

    >”Where are you getting this number?”

    From Google finance. I pick the “2008 highs” to maximize the possible ‘devaluations in response to the crisis’ to see if these currency narratives are sensible.

    On 06-June-2008, 1 Swedish Krona bought 16.91 cents. Today it buys only 12.95 – a decrease of 23.4% in dollar terms. The five-year change, however, is only -1.6%.

    On July-11-2008, One Euro bought $1.59, today it buys $1.24. That a decrease of 22%. Interestingly, the five year change in the Euro is still slightly positive, at 1.9%. On the other hand, the Euro’s been a little volatile as of late, and has traded as low as $1.19 on June 8th, which would have been a peak decrease of 25%, and zero change in five years.

    In other words – in American Dollar terms anyway, movements in the Krona and the Euro are nearly indistinguishable.

    On 14-March-2008, one British Pound bought $2.02. Today, $1.48 a decrease of 26.7%. If I were to go back a little further – on 02-Nov-2007, it bought even more, $2.09, which would imply a decrease of 29.2%. The five year change is significant, -18.8%.

    Now, this is not much different from the Euro and the Krona in the last 2 years. But the British have a slightly larger peak-decline devaluation, and a much larger five-year decline. If we’re going to tell nice stories about nations ‘better weathering of the storm through relative currency devaluation’ – that story should also explain why Britain is not doing better, or at least comparably well with, Sweden.

    Then again – what do we mean “better”? We don’t really know the counter-factual – do we? Maybe Britain *is* doing better than Sweden in terms of the improvement of its present condition over *where it would be* without these currency movements.

    Using “changes from the counter-factual” seems reasonable (if very uncertain) to me in some circumstances: “Jobs created or saved” anyone? But then it would be unreasonable to look merely at actual changes in employment or trade vs currency movements as ‘evidence’ of anything.

    I think the people making these arguments are smart enough to see all of this before they utter a single word. I could be snarky and ask “Why oh Why can’t we have better Neo-Keynesian Economists and Progressive Commentators?” but I won’t.

  16. Gravatar of JNP JNP
    18. June 2010 at 06:11

    Why is the UK government so much larger, without apparently producing any better public services?

    A lot of the hiring under New Labour was bureaucrats rather than teachers/doctors/etc. NHS productivity actually declined over the period 1997-2007.

  17. Gravatar of scott sumner scott sumner
    18. June 2010 at 08:00

    I discussed many of these great comments in my new post. But I’ll make a few more comments here:

    Jon, See the new post.

    Marcus, Thanks for the data. I recall that the Labour government was expanding government’s share of GDP even before the recession hit.

    Statsguy, Thanks, I mentioned this in my new post.

    Tatonnement, Thanks for the revealing data. See my new post.

    Indy, Good point, although part of that was the inflated level of the euro in early 2008. Using other starting points the pound and kronor usually fell against the euro. But overall I agree. The exchange rates don’t tell us much in this case.

    Doc Merlin, That’s a good point about economists often confusing correlation and causation when it comes to exchange rates.

    William, Thanks for the useful data, and I think it shows we can’t read too much into the exchange rate data cited by DeLong and Yglesias (and me.) It is more complicated.

    Lorenzo, Yes, great comments.

    Econoclast, Lots of good points. The British probably have a bit of the Dutch disease, which means they need to run surpluses in their budget. Instead they acted like California and NY, assuming the boom would last forever and boosting public spending.

    As for the public not saving enough, they ought to replace some of their social insurance programs with forced saving.

    W le B, Thanks, more evidence that money is tight in Britain.

    Stastguy#2, One other point is relevant here. Currency depreciation can overcome the monetary policy credibility problem at the zero bound. That’s because at the zero bound a depreciation in the spot rate causes an almost identical depreciation in the forward rate.

    JNP, Good points. I’d add that I don’t believe Britain has better health care or education than Canada. My hunch is that their government spends a lot more, but they don’t have much to show for it. Someone correct me if I am wrong.

  18. Gravatar of StatsGuy StatsGuy
    18. June 2010 at 11:44


    “Stastguy#2, One other point is relevant here. Currency depreciation can overcome the monetary policy credibility problem at the zero bound. That’s because at the zero bound a depreciation in the spot rate causes an almost identical depreciation in the forward rate.”

    I’m still a bit hung up on this part. Do you mean devaluation by dropping the peg below the implied floating rate and direct central bank currency intervention (China), or devaluation by printing extra money and letting the currency float (US, in its brief moment of lucidity)?

    Here’s an interesting case: Swiss intervened recently to suppress the franc vs. the euro, due to competitiveness concerns. Markets looked at this (it became obvious that a central bank was intervening), and after an initial spook they deemed that the Swiss bank was hoping this was a temporary intervention, and hoped to avoid creating domestic inflation which would be the natural result of committed intervention to achieve parity. In response, they purchased francs at the swiss bank subsidized rate, then kept buying them until the swiss bank admitted it didn’t really want inflation – just to keep the franc low relative to the euro. Swiss franc rises, and speculators now own lots of valuable francs. Swiss bank stops selling francs because they get scared about holding massive euro reserves (what if the euro falls and keeps falling?) – now they are committed to eventually buying back those sold francs with cheaper euros at a real loss (though possible nominal parity), or they are committed to never selling euros back and admitting that they just gave away a bunch of swiss francs to foreign speculators at well below par value.

    The credibility problem is not so easy to circumvent, precisely because the markets like to figure out ways to arbitrage things. It comes down to this: if a central bank wants its economy to stay competitive, they have to be willing to tolerate price (especially import) increases, OR they need to have higher productivity. Any short term intervention is arbitraged away and currency speculators say “thank you for the present”.

    In other words – if you want a stable price or NGDP trajectory, you need to really mean it and be prepared to prove that you mean it. If you bluff, markets will call the bluff, and if you don’t follow through, they will take central banks to the cleaners.

  19. Gravatar of Contemplationist Contemplationist
    18. June 2010 at 12:52

    We know Brad Delong knows his economic history. We know he’s a good teacher of economic history. As such, we know he’s a dishonest Democratic hack. Anyone who continues in 2010 to peddle the stupid lie of Hoover being a laissez-faire liquidationist needs to be taken to the woodshed. As simple as that. Just like Delong and Krugman took some right-wingers to the shed for the “treasury view’ idiocy, this nonsense cannot remain.
    It is a matter of FACT not even of opinion or analysis.

  20. Gravatar of Doc Merlin Doc Merlin
    18. June 2010 at 14:38

    Interesting post.

  21. Gravatar of scott sumner scott sumner
    19. June 2010 at 07:45

    Statsguy, I just meant that a country that wants to inflate can just depreciate their currency. I agree that if they don’t want to inflate, then they might back off on currency depreciation. My point is that there is no trap, they can depreciate the currency if they want inflation. You are quite right that the Swiss central bank didn’t want inflation, just a lower real exchange rate. You have to take the sweet with the sour.

    But this isn’t a credibility problem it’s a question of what the Swiss want.

    Krugman also mentioned the Swiss case, and it is an interesting case. But just be be clear it tells us nothing about the predicament of central banks that want to inflate, because the Swiss don’t want to inflate.

    BTW, If the Swiss want low inflation and a stable real rate then one solution would be to appreciate 1% a year against a trade weighted basket of currencies. I think the Brazilians once did this in the opposite direction (crawling peg?).

    Contemplationist, Hoover was definitely not a supporter of laissez-faire. He did favor tight money to kill the stock market bubble.

  22. Gravatar of StatsGuy StatsGuy
    19. June 2010 at 17:34

    “My point is that there is no trap, they can depreciate the currency if they want inflation. You are quite right that the Swiss central bank didn’t want inflation, just a lower real exchange rate.”

    Well, yes – precisely. But if the Swiss _really_ want inflation, then there are other ways to get it besides currency depreciation (like printing and spending money). The point is that the currency depreciation mechanism doesn’t solve the credibility problem at the zero bound. The credibility problem is that capital markets believe the central bank really _doesn’t_ want inflation (but still wants people to make investments and consume). In currency markets, the credibility problem is that capital markets believe the central bank really _doesn’t_ want inflation (but still wants to keep the exchange rate favorable).

    In both cases, if the central bank really does want inflation, it can get it. The credibility problem is that they _don’t_ want inflation, but want something else that usually has a side effect of inflation. Depreciation does not by itself solve the credibility problem; actually wanting inflation solves the credibility problem, regardless of whether the mechanism is depreciation or QE or whatever.

    They’ve got to actually _mean_ it, and sometimes they have to _prove_ they mean it (even if this requires doing something irrational). I suppose it’s like dating.

  23. Gravatar of Scott Sumner Scott Sumner
    19. June 2010 at 18:28

    Statsguy, I don’t see the credibility problem in quite the same way as you do. You said:

    “They’ve got to actually _mean_ it”

    Sure they have to mean it, but I thought the credibility problem referred to a situation where the central bank did mean it, they did want inflation, but the markets didn’t believe them. I.e. the central bank had trouble convincing the markets that it was serious. Now let’s assume that is the problem. Then consider the following two scenarios:

    1. They print lots of money and spend it on common stock
    2. They depreciate the currency

    The first policy will have no effect. Because the markets don’t think they are serious, they’ll expect the monetary injection to be temporary. They’ll expect the stocks to be sold next month, and the cash to be withdrawn from circulation Thus it won’t boost prices.

    The second policy will immediately cause inflation through the PPP effect, even if the policy has zero credibility. You can’t fight the central bank if is determined to sell unlimited currency at a lower price. It can make the market.

    BTW, what if the central bank doesn’t “mean it”? In that case there is no problem—they don’t want inflation and they don’t get inflation.

    Of course you can’t target two variables at once, so you must decide whether you care more about the price level or the real exchange rate, if there is a conflict.

  24. Gravatar of StatsGuy StatsGuy
    20. June 2010 at 05:15

    OK, I get it… if the central bank is willing (and actually does) buy and hold unlimited amounts of forex, it will get depreciation (and inflation). True. But, I would also say that if the central bank is willing (and does) buy and hold unlimited amounts of common stock, it will also get inflation.

    So I agree that Switzerland wasn’t a case of a central bank trying to get inflation. However, if Switzerland wanted inflation and markets didn’t believe them (i.e. they thought the Swiss were trying to depreciate but avoid inflation), then markets would arbitrage the Swiss Bank purchase of foreign currency, and this would _force_ the Swiss to _prove_ they meant it.

    I suppose for a CB buying common stock, it’s possible that the sellers of common stock just hold cash no matter the size of the purchase and we have a massive buildup in reserves. But if the CB buys foreign currency, then even if the sellers of foreign currency hold the CB currency as cash, this will _eventually_ reduce the supply of the foreign currency to the point where we’ll see that currency appreciate in value, which will force domestic inflation in the CB country at the expense of deflation in the trading partner (unless the trading partner’s credit markets or CB compensate).

    I suppose a central bank could buy a bunch of forex, and then spend the forex on goods and services or otherwise inject it into the local economy. But this is almost equivalent to printing and spending domestic currency. If the CB’s intent is just to hold the foreign currency and sell it back later, I think it’s closer to the CB buying assets with the intention of selling them next month – currency markets will arbitrage the time, and restore close to par value (minus the carry costs and risk). [But then, the carry costs and risk still leave a gap, which means we’ll see some residual depreciation (and inflation).]

    But either way – let me say that I fundamentally agree with you that if a central bank really _does_ mean it, then they can get inflation either way. The problem is, they don’t, they just want markets to think they do, which is why they keep backing down (e.g. Japan).

  25. Gravatar of ssumner ssumner
    20. June 2010 at 07:21

    Statsguy, You said;

    “I suppose for a CB buying common stock, it’s possible that the sellers of common stock just hold cash no matter the size of the purchase and we have a massive buildup in reserves. But if the CB buys foreign currency, then even if the sellers of foreign currency hold the CB currency as cash, this will _eventually_ reduce the supply of the foreign currency to the point where we’ll see that currency appreciate in value”

    Keep in mind that there is no “eventually” here. If the BOJ say that in 5 minutes the yen/dollar exchange rates falls to 125 yen to the dollar, then the change happens in five minutes. No one will buy yen in the forex market for a cost of $1 per 90 yen, when they can simply go to the BOJ and pay $1 for 125 yen. So the exchange rate is the instrument of policy. It’s no different than changing the fed funds target. Usually people don’t say; “Eventually the fed funds rate changes if the Fed lowers its target, and only if the policy is credible.”

  26. Gravatar of Doc Merlin Doc Merlin
    20. June 2010 at 13:47

    The price level isn’t what matters.
    What matters is the relative prices of different classes of assets. Imo, monetary expansion (even if expected, and even in a perfectly efficient market) works by making nominal assets (like debt) temporarily cheaper, while making real assets (cpi, ppi, etc) more expensive.
    This mainly does two things:
    1) A substitution effect makes savers spend more
    (There is a wealth effect too, but it can go either way, depening on how the people saved. Since roughly half of earnings tend to be saved in non-nominal assets, like houses, I’d say the wealth effect probably balances out.)

    2) An income effect makes borrowers spend more (because the cost of borrowing from future income is reduced drastically).

    People should stop talking about index inflation as if it is the cure (or even principle reason to have monetary expansion) for recession. What is important is the monetary expansion directly affecting relative prices in different classes of things differently.

  27. Gravatar of ssumner ssumner
    21. June 2010 at 09:08

    Doc Merlin, In my view it is unexpected money that affects relative prices.

  28. Gravatar of Doc Merlin Doc Merlin
    21. June 2010 at 17:13


    Is that because if money is expected, the effect gets arbitraged away?
    That makes sense to me. If not, what is your mechanism?

  29. Gravatar of ssumner ssumner
    22. June 2010 at 06:17

    Doc Merlin, Expected money is factored into wage and loan contracts.

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