In my recent book entitled **Alternative Approaches to Monetary Policy**, I described two different low interest rate monetary policies, one expansionary and contractionary:

Because of the interest parity condition, we know that these are both low interest rate policies. International investors will accept a lower interest rates in safe assets located in countries where the currency is expected to appreciate over time.

And yet the US example (often dubbed overshooting) is an expansionary monetary policy, which leads to a weaker currency in the long run, while the Swiss example is a contractionary policy, with a stronger franc in the long run. Reasoning backward, we cannot assume anything about the stance of monetary policy merely by looking at the change in interest rates. Both countries saw lower nominal rates, but one policy shock was expansionary while the other was contractionary.

Interest rates are not monetary policy!

In a recent post, **John Cochrane** presents a very similar example, but with a different framing. His graph shows two cases of higher interest rates (currencies expected to appreciate), but note that he also presents both expansionary and contractionary monetary shocks:

Here’s how Cochrane explains the graph:

The picture shows the possibilities. Suppose the interest rate rises for three periods, as shown. What happens to the exchange rate? Well, a higher interest rate at t must imply expected depreciation from t to t+1, so there must be three periods of depreciation while the interest differential persists. The solid red line shows that possibility. Once the interest rate returns to normal, the exchange rate stops moving, but at a permanently lower level. (The exchange rate is a difference of price levels, so it keeps going down as long as inflation is higher.)

But as before, the international Fisher equation is by itself not a complete model. It does not say what happens to the exchange rate at time t. That rate can jump up or down. The dashed lines show three possibilities. The exchange rate could jump down and then continue on its depreciation. The exchange rate could jump way up, and then depreciate. Or, the exchange rate could jump up just enough so that expected depreciation brings it back to its original level.

We’re back in the equilibrium-selection swamp of my last post. Standard models now add ingredients in order to pick the equilibrium where the exchange rate goes back to its earlier level. So, the standard answer:

Why do higher interest rates raise the exchange rate? Well, higher interest rates cause a depreciation. But the exchange rate first jumps up so that it can now depreciate back to its initial level.But why should the exchange rate revert to its earlier level? That is the Achilles heel of this story. There is no natural force that brings nominal exchange rates back. Since the exchange rate is a ratio of price levels, we need to think about what the price-level nominal anchor is.

Obviously there’s a lot of similarity about what John is doing and what I was doing. We are both heterodox economists, critical of the standard model. But there’s also an important difference. My takeaway is that it is simply wrong to talk about monetary policy in terms of interest rates—that doing so represents the *fallacy of* *reasoning from a price change*.

Cochrane believes that we need to think about monetary policy in terms of interest rates, because that’s how things work in the real world. But he sees the problem, which he regards as a sort of indeterminacy, or “multiple-equilibrium” issue. His search for a solution, a way of pinning down which path is the actual path, led him to the “Fiscal Theory of the Price Level”:

The bottom line: The standard view of how interest rates affect exchange rates suffers many of the same problems as the standard view of how interest rates affect inflation. For young researchers, this is great news. The most basic policy exercise of all in international economics is up for grabs. I am hopeful that fiscal theory at last solves the gaping multiple-equilibrium hole, and that by treating inflation and exchange rates together as joint outcomes of policy we will make some big progress.

I’d prefer to pin things down by targeting the market forecast of NGDP growth, perhaps using futures contracts.

It would be good to have John on the market monetarist team. He has far better technical and writing skills than I have, and would immediately become the leader of this small school of thought. Unfortunately, he’s a bit allergic to the monetarist approach. We’ll have to content ourselves with having a powerful ally in our critique of the standard model, even if he is promoting a different alternative model.

Over at my new blog, I have a **related post** for those who wish to take a deeper dive into the subject.

## READER COMMENTS

## Thomas L Hutcheson

## Sep 30 2024 at 6:46pm

“Interest rates are not monetary policy.”

I agree, but Cochrane’s language, “interest targeting” suggests that it is. It is confusing to discuss the effects of the movement in one instrument without specifying what outcome variable is being targeted.

## Thomas L Hutcheson

## Sep 30 2024 at 7:01pm

“I’d prefer to pin things down by targeting the market forecast of NGDP growth, perhaps using futures contracts.”

I’d still like to know why this would be better than the current Fed policy of FAIT (assuming that the “average” it is targeting is a forward-looking, presumably market-informed trajectory)?

And operationally what would be the movements of possibly different policy instruments in response to

Positive sectoral supply shock?

Negative sectoral supply shock?

Negative sectoral demand shock?

Positive sectoral demand shock?

## Scott Sumner

## Oct 3 2024 at 12:05pm

There are many types of “flexible” AIT. I view NGDP level targeting as the best of them, as it is NGDP instability that causes problems for the labor market and the financial system.