Thursday, December 15, 2011

How does an undervalued currency give the country using it an unfair price advantage?

How does an undervalued currency give the country using it an unfair price advantage?|||Consider a country C each of whose workers produce one widget per hour. Let's also suppose that the Y is the currency of country C and that each worker gets paid 1 Y per hour. That means it costs 1 Y to produce a widget (ignoring all the other costs such as raw materials, etc.)



Now suppose that the exchange rate between the Y and the dollar is 1 to 1 - $1 buys 1 Y. Then each dollar will buy 1 widget so the price of widgets is $1 per widget.



But then suppose the Y is a pegged currency (not free to float)

http://en.wikipedia.org/wiki/Fixed_excha鈥?/a>

and the government of C chooses to change the exchange rate to 2:1 - $1 now buys 2 Y.



Since wages and prices tend to be sticky, the price in country C of an hour of labor will still be 1 Y and so the price of a widget will still be 1 Y. But now, someone with a dollar can buy 2 Y and hence buy 2 widgets.



Expressed in dollars, the price of a widget has gone from $1 per widget to $0.50 per widget.



Thus by lowering the exchange rate the government of C has made its exports cheaper and hence more attractive to the rest of the world.



Whether this is unfair and to whom is a matter of discussion and the context. If the Y were floating, then the market would determine the exchange rate, not the government of C. But if the government C keeps the exchange rate close to what the market would have had it, then the exchange rate would change and the changes would not necessarily be unfair.



On the other hand, the government of C could change the exchange rate to a value significantly different from what the market would have it. In this case, reducing the value of Y is equivalent to an export subsidy at the cost of the standard of living of the consumers of C.



If some other country A were at full employment, then this subsidy for exports from C to A does not hurt A but helps - a free gift. But if A is not at full employment, then the subsidy can end up transferring jobs from A to C leaving A worse off. In this case, A may argue that the undervaluing of the Y is unfair.

http://krugman.blogs.nytimes.com/2009/12鈥?/a>



(It is possible for a country with a floating currency to affect the value of that currency, but:

- It is harder and much more expensive to move the market value

- So the movement can only be short term)|||Undervalued? By whom? If it were undervalued, people would trade for more of that currency, and it would no longer be undervalued.

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