Value and disvalue of a strong currency v2 Wenfa Ng figshare 25 Nov 2016.pdf (334.1 kB)
Value and disvalue of a strong currency
Version 2 2016-11-25, 09:26
Version 1 2016-11-24, 12:15
journal contribution
posted on 2016-11-25, 09:26 authored by Wenfa NgWenfa NgDepending
on whether you are a political scientist or an economist, there are
dichotomously different views on the utility of a strong currency.
Specifically, political economy argues that a strong currency is the buttress
of a strong country; on the other hand, micro and marcoeconomics put forward
the view that a currency’s value ebbs and flows depending on market forces and
economic fundamentals. But, what are the advantages and disadvantages of a
strong currency? It depends on the structure of the economy, and the strength
of its fundamentals relative to major trading partners. A weak currency, which
is also an undervalued currency, is useful if the country relies heavily on
exports to the world. These exports could be electronics, agricultural or
services. Hence, given the argument that a country needs to export goods to
earn income for the economy, would an undervalued currency be preferable over
an overvalued (strong) one? The answer requires the examination of the other
side of the equation: the role of imports to an economy. If the country is an
open economy with the need to import raw materials or semi-finished products
for final assembly, a strong or slightly overvalued currency would reduce the
cost of imports and the final price of the exported product, making it more
competitive in the international market. On the other hand, if the
manufacturing process rely less on imports of components, a weak or undervalued
currency would boost the export of the final product as it is cheaper after
accounting for currency differentials. Hence, it is a trade-off between the
relative balance of imports and exports that flow in and out of an economy that
suggests a suitable price for a currency that would have, overall, a balanced
effect on the economy: i.e., no significant advantage and disadvantage in
either direction. The economic measure of this is terms of trade - the relative price of imports versus exports.
Therefore, one may ask: how should the exchange rate be set? And on what
timescale? Daily or monthly? Should the currency's price be based on a benchmark
interest rate, bank reserve requirement, or on a basket of currencies of the
major trading partners of a country? Or alternatively, could a currency’s
exchange rate be set based on changes in terms of trade of a country against
the major trading partners of an economy? Using data from the daily
fluctuations of a currency in the foreign exchange markets, does the movement
in price of the currency correlates with that of terms of trade, which provide
some measure of economic fundamentals in pricing a currency; thereby, helping
sort out the portion of a currency’s price underpinned by financial flows and
sentiments in the market. On the other hand, is terms of trade a better reflector
of the dynamic operation of an economy, and thus, tells a cogent tale of the
monthly (not daily) fluctuations in exchange rate, where daily price
differences in a currency get their information input from relative demand and
supply of the currency in the markets? At the fundamental level, is it possible
to calculate a theoretical value of a currency based on one measure: terms of
trade, and what timescale is it good for; for example, on a monthly or quarterly
basis? Economists who find the above ideas and questions useful may expand on
them in their research.