Monday, 10 December 2012

The Curious case of the $A

It used to be easy to know the direction of the $A. It merely followed the direction of the terms of trade ( in other words commodity prices).

However in recent times commodity prices have fallen BUT the $A has remained at high levels. why?

It appears sovereign wealth funds find the yields on our government bonds with its AAA rating from all three rating agencies (The only time thus far this has occured) irresistible.

The $A being at high levels is contractionary for the economy. This combined with fiscal policy is outweighing the stimulatory effects of lower interest rates.

Indeed it appears to be the major reason why nominal GDP levels has been lower than trend for sometime and why disinflation has made real GDP higher then nominal GDP.

Can this continue?

Ricardian Ambivalence believes it can.( see the comment on the jobs article). He thinks it can as long as the terms of trade keep falling. You then get a European situation of net exports only rising through very low wage growth.
In other words very tepid growth which means rising unemployment.

How does a policy maker change this?

Well a loosening of fiscal policy would achieve this. You would then get expansion through both fiscal policy and a lower $A. However as the economy expands and then you get a tighter fiscal policy you then get back to a stronger $A than the fundamentals would lead you to.

The problem at present is that old fashioned fundamentals has taken a back seat. It seems to me it will continue to do so whilst the European crisis continues.

An old fashioned Keynesian would find himself in a bind. At present the government is following Keynesian policies. A reliance on monetary policy with fiscal policy going from neutral to contractionary.

What to do?