Interest Rate as Policy Choice, Exchange Rate as Degree of Freedom

The previous post discussed a short paper by Paul Krugman on the “invisible bond vigilantes” and noted convergence, on the issue, to the position of Modern Monetary Theorists. Briefly, the bond vigilantes, in the view of both Krugman and Modern Monetary Theorists, are not so much an “invisible” as a nonexistent threat to nations that satisfy four conditions:

1. The government is a currency issuer;
2. The exchange rate floats;
3. The monetary authorities set the interest rate;
4. The government avoids borrowing in foreign currency.

Under these conditions, as Krugman points out, there is little reason to expect a loss of confidence in the currency, but if there were, the impact would be more favorable than in the case of nations operating under fixed-exchange-rate or common-currency arrangements. For non-economists among us, this point seems worthy of elaboration.

In his paper, Krugman writes:

Think about it this way: with the Fed setting interest rates, any loss of confidence in US bonds would cause not a rise in rates but a fall in the dollar – and a fall in the dollar would be a good thing, helping make US industry more competitive.

We can unpack this statement a little by briefly comparing the implications of the different currency arrangements.

Fixed exchange rate or common currency

Under a fixed exchange rate, assuming there is a commitment to that exchange rate, a loss of confidence in the currency will force the central bank to intervene to maintain the currency’s (external) value. As demand for the currency drops, the monetary authorities will need to bring about a rise in interest rates to attract capital inflow.

In this framework, the interest rate plays the role of what Edward Harrison calls the relief valve, which has implications for the costs of servicing public debt.

Of course, in the case of an individual nation, there could be a revaluation of the currency, rather than a defense of it. In a common-currency arrangement, such as the European Monetary Union, the policy constraint on individual nations is more binding. The essential point, though, is simply that if the central bank intends to defend a particular exchange rate, it is the interest rate that provides a degree of freedom, bearing the brunt of any market pressures.

The implication is that a loss of confidence requires a macroeconomic policy response from government that will only further destabilize the economy. For one thing, the necessary increase in interest rates, brought about through a tightening of monetary policy, is likely to be somewhat contractionary. For another, and more importantly from the perspective of Modern Monetary Theory, the higher interest rates, by raising the cost of debt servicing, will limit the ability of governments to maintain aggregate demand through net expenditure.

In short, a loss of confidence will require policies that exacerbate the situation.

Floating exchange rate

Under a floating exchange rate, assuming the monetary authorities are committed to their interest-rate target, a loss of confidence will result in depreciation of the currency. In this case, the exchange rate provides the relief valve. As long as the government has not borrowed significantly in foreign currency, its ability to service debt will not be inhibited.

The central bank could, if it wished, alter its interest-rate target in an attempt to limit exchange-rate movements, but this would be a deliberate policy choice not dictated by market pressures.

If, instead, the central bank commits to the interest-rate target, it will be the exchange rate that bears the brunt of any loss in confidence. Such currency depreciation, as Krugman points out, tends to be expansionary, because it lifts the competitiveness of export and import-competing industries.

So, under a floating exchange rate, a loss of confidence neither undermines the government’s capacity to pursue appropriate net expenditure nor compels an alteration in monetary policy, provided the government eschews borrowing in foreign currency.

If, not when

In closing, it is worth reiterating that all this discussion has been predicated on there being a loss of confidence in the currency. In reality, there is little reason to expect a loss of confidence in nations with their own currencies, provided government net expenditure is for the purposes of closing the output gap and the four conditions emphasized both by Krugman and Modern Monetary Theorists all apply.