Friday, April 11, 2008

Inflation and Globalization

A side effect from having worked at the Federal Reserve is that my attention automatically gets drawn to certain topics. One of the more common topics is inflation. If one adheres to Milton Friedman's old adage that "inflation is always and everywhere a monetary phenomenon;" one tends to link inflation to monetary policy, and then back to the Fed. This explains, at least in part, my interest in the story I'm referencing.

Yesterday's edition of The Wall Street Journal had, on the front page, an excellent piece about inflation and globalization (now subscriber content). What I found most interesting and valuable was the way it linked rising price pressures around the world. It mentioned wage pressures in Germany, demand pressures in Asia and other developing countries, energy price pressures, and monetary policy. Especially interesting in the last area, was how the decision of several countries to peg their currencies to the U.S. dollar has ended up with those countries essentially importing inflation.

A nation with a currency pegged to the dollar is actually fixing the exchange rate of their currency to the U.S. dollar. This means that under all circumstances, the nation in question will adjust its money supply to maintain a constant value relative to the U.S. dollar - say 7 to 1.

In the U.S., the Federal Reserve has been faced with mounting price pressures at the same time it confronts an economic slowdown evolving out of current credit conditions. Various spokespersons within the Federal Reserve System have stated that the perceived greater risk is a slowdown. Consequently, monetary policy has been expansionary as evidenced by lower short-term interest rates and increased lending by the central bank.

For nations with currencies pegged to the dollar, this has resulted in a looser monetary policy. But these countries have not necessarily been faced with the same economic slowdown. Consequently, more money in their system has translated into higher price pressures.

But the most interesting thing about this article is the global aspect. The inflationary pressures are not restricted to the U.S. and countries with pegged currencies; they are everywhere. In some nations, one of the key benefits of globalization - increased wages - has resulted in increased demand for goods and service, driving up prices. In others, the increased demand for commodities in one part of the world has rippled through to another.

The concepts of money, inflation, interdependence, markets, and economic growth and development are all touched upon the article. Whether you use the article as an assigned or supplemental reading in class, or just read it for your own benefit, I strongly recommend it.

I look forward to your thoughts, as well as your students' reactions.


Mike Fladlien said...

I was taught that a country that pegs its currency to another country, adopts that country's monetary policy. In "The World is Flat", the author agrues that two countries with a McDonalds will not go to war with each other. I think the same argument can be made about a country that adopts another's currency.

Tim Schilling said...

I think you're long as the peg stays in place. One could certainly argue that if the peg is causing harm, it's time to disconnect.

I believe the benefit of a peg generally exists early on for the pegging country. Once a level of responsibility and stability has been demonstrated, I would guess the effect wears off.

Any thoughts?

Mike Sproul said...

Here's a belated thought:

If the Mexican central bank's assets consist of 10 paper dollars, plus Mexican government bonds worth $90, and if the bank has issued 100 pesos, then they can peg the peso at $1. But if that bond falls to $89, then they have $99 of assets backing 100 pesos, so any attempt to maintain the $1 peg will result in a bank run, since nobody wants to be stuck with the last peso. This would happen whether the bank has demonstrated responsibility or not.