A Reason to Teach Macro
By Arnold Kling
In Europe, the price of oil has risen by 50 euros in the past five-and-a-half years. It now stands at about 75 euros per barrel, three times what it was then. But in the U.S., the price of oil has risen to over $120 per barrel, and is now almost five times what it was then.
The sole reason for this enormous difference is the incredible depreciation of the dollar against the euro. From one for one at the end of 2002, it now costs nearly $1.60 to buy a euro.
…Exchange rates can be managed. We need exchange rate policy.
In order to know whether we need an exchange rate policy, one needs a theory of exchange rates. I’m not sure what theory of exchange rates I believe, but I find myself tempted to fall back on what I learned in international macro.
One of the things we learned was that you can use monetary policy to target the domestic inflation rate or to target the exchange rate, but not both. If we wanted to bring back parity between the dollar and the euro, then this macro theory suggests that we would have to cut back on the money supply considerably, probably enough to cause serious deflation. As a cure for high oil prices, that would likely be much worse than the disease.
Having said that, I have my doubts that we have a reliable theory of exchange rates. I have particularly strong doubts that we have a reliable theory of exchange rate intervention.
One might like a simple monetarist story in which the money supply determines the price level and in which relative price levels determine exchange rates. But the definition of the money supply is difficult to pin down in the modern world, and the purchasing-power-parity model of exchange rates barely can be made to fit in the long run, much less the short run.
Still, one should learn macro before reading (or dare I say writing) a piece that makes it seem as though exchange rate manipulation is a painless cure for high gas prices.