Sunday, February 3, 2013

Quote of the Week... from “The Economics of Exchange Rates and the Dollarization Debate: The Case against Extremes” by Thomas I. Palley:
Historically, the onus of defending the exchange rate has fallen on the country with a weakening exchange rate. This requires the country to sell foreign exchange reserves to protect the exchange rate. Such a system is fundamentally flawed, because countries have limited reserves, and the market knows it. This gives speculators an incentive to try and "break the bank" by shorting the weak currency, and they have a good shot at success given the scale of low-cost leverage that financial markets can muster. Recognizing this, the onus of exchange- rate intervention needs to be reversed so that the country with strong currency (the central bank with an appreciating exchange rate) is responsible for preventing appreciation, rather than the country with weak currency being responsible for preventing depreciation (Palley 2003). Because the bank with strong currency has unlimited amounts of its own currency for sale, it can never be beaten by the market. Consequently, once this rule of intervention is credibly adopted, speculators will back off, making the target exchange rate viable. Such a procedure recognizes and addresses the fundamental asymmetry between defending weak and strong currencies. (2003: p. 78-79) (emphasis added)
This quote and paper by Palley ties in nicely with an earlier post this week on “The Impossible Trinity or The Permanent Floor: Adding Modern Money to Mundell-Fleming.” Weak global economic growth and high unemployment continues to permit experimentation in monetary policy. While many economists have yet to fully comprehend the change to a floating fiat currency, even fewer appear to completely recognize the transformation currently taking place. Although this paper helped fulfill a current homework assignment, it’s also part of a broader literature review that will hopefully lead to my first publishable paper. My goal is to further establish these ideas in unison with the “Permanent Floor” in order to present recommendations for a more comprehensive global monetary framework. Wish me luck!

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