Arnold Kling

Other Pygmies

Arnold Kling, Great Questions of Economics
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Paul Krugman posted to his web site some analyses of recent events. In Argentina's Money Monomania, he writes,

My New York Times readers are, I hate to admit, not as interested in Argentina as they should be, so I am placing it here. I hope someone sees this, and that it is of some use.

I saw it, and I found it more interesting than his Times columns.

Krugman argues that an overvalued exchange rate does macroeconomic damage in two ways. First, it adversely affects the balance of trade. Second, it leads to deflation, at least in relative terms. Discussing Argentina and Japan, he writes,

Suppose that your country is committed to a fixed nominal exchange rate and that the currency is overvalued. What I mean by "overvalued" is that the price of domestic goods, relative to foreign goods, is higher than it would be if all prices were completely flexible. What one would expect to happen in this case is a process of deflation -- certainly relative deflation, with the domestic inflation rate less than the foreign, and quite possibly actual deflation too.

Krugman says that for a given nominal interest rate, this deflation means a high real interest rate. One of the benefits of a currency depreciation is that it eliminates the deflation and thereby lowers the real interest rate.

Discussion Question. Steve Roach (See post 31, below), thinks that the United States needs a currency depreciation because of its trade deficit. Krugman believes that Japan needs a depreciation in spite of the fact that it runs a trade surplus. Can one reconcile their views?

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