Lessons from monetary and real exchange rate economics.

• Author: Harberger, Arnold C.
• Position: Essay

This article is intended to be a sort of flyover, examining certain key aspects of monetary and real exchange rate economies from a convenient distance. In it I try to avoid getting into technicalities that are interesting mainly to specialists. I focus instead on essentials that are critical to a proper understanding of the economic processes involved, and on a few real-world examples that show the usefulness and relevance of our fundamental theoretical constructs.

It pays to simplify by dividing our analysis into two parts: one concerned with the "real economy" dealing with quantities and relative prices, and the other dealing with the determination of the absolute level of prices. This is called the classical dichotomy; it has for years been a critical pillar of economic theory.

When we try to apply the classical dichotomy, we need to settle on a unit, in terms of which we express relative prices. While in theory this unit, called the numeraire, could be any price (e.g., that of oil, sugar, or copper), in practice it is greatly simplifying to use a general price level as the unit of analysis--either the GDP deflator, a general index of the prices of all the goods and services produced in the economy, or the consumer price index, a general index of the prices of all the goods and services consumed in the economy.

The Real Exchange Rate

When dealing with international trade, we must bear in mind the important distinction between tradable and nontradable goods. Tradable goods are those whose prices are fundamentally determined in the world market. These are the actual exports and imports of a country, plus some goods that might be importable or exportable. Tradables and nontradables are key categories, but many products can be seen as mixtures of the two (cars and gasoline are tradable, the services of bus and taxi drivers nontradable; food and equipment are tradable, the services of restaurant personnel nontradable).

Because of the complication of these mixed commodities, it is best not to seek a direct index of nontradables prices, but to use as much as possible one of the two general indexes, in which nontradables automatically receive their due weight. This consideration leads to the most practical definition of the real exchange rate: how many of a country's own consumer baskets (defined by the CPI) or producer baskets (defined by the GDP deflator) does it take to buy one basket of tradable goods.> We have as yet no consensus measure of a standard basket of tradables, but best practice uses a weighted average of the wholesale price indexes of a number of countries. (Wholesale price indexes are known to have a heavy concentration of tradables.)

The real exchange rate is the principal equilibrator of a country's trade and payments. Broadly speaking, when foreign currency is very abundant (as a result of high export levels or large capital inflows or emigrant remittances or foreign aid), the market sets a low real price on foreign exchange. In the opposite case, when a country suffers from an export slump or has to make big debt repayments, the market sets a high real price for foreign exchange. When we speak of the real exchange rate as the equilibrator of the country's trade and payments, we count all sources of inflow of foreign currency and all types of outflow (including the central bank's accumulating international reserves).

Two Key Propositions of Monetary Economics

The first proposition of monetary theory is that people behave in regular and rational ways in determining their desired holdings of real monetary balances. These are usually defined as some concept of "broad money" (usually M2), deflated by either the CPI or the GDP deflator. Key variables in determining these holdings are the level of real income, the expected rate of inflation in the country, and real interest rates (i.e., nominal interest rates corrected by the expected rate of inflation). Higher interest rates paid on monetary balances themselves lead to larger real balances; higher interest rates on treasury bills, bonds, etc., lead to smaller real balances.

The second proposition of monetary theory is that when people find themselves with monetary balances higher than they really want, they tend to spend more, thus bringing their balances closer to the desired level. Likewise, when their monetary balances are lower than their desired level, people tend to spend less than they otherwise would, bringing their real balances closer to the desired level.

This dynamic process of spending more when real cash balances exceed their desired level, and less when real cash balances fall short, is the principal way in which "too much money" leads to a higher price level and "too little money" to a lower price level.

A corollary to the second proposition, is that yes, the monetary authorities determine the nominal money supply (MS), but as people adjust their spending, the price level (P) changes so as to bring [M.sup.s]/p into equality with the people's desired real monetary balances [(M/p).sup.d]. Thus, it is the people who determine the red money supply. The big inflations of the past all testify to the validity of this proposition. Since inflation is in effect a tax on real cash balances (M2/P), people hold much lower real balances under inflationary conditions than under more stable...