Wednesday, November 7, 2007

Exchange Rate Volatility

For some time, price stability has been a major concern of many central banks, Canada obviously included. We have accepted that price volatility entails a significant real cost. Yet, we have also made allowances that relative prices need to adjust.

So, where do we draw the line between curtailing the perhaps not as significant, but definitely real and definitely growing cost of volatility in exchange rates? Now, I'm not advocating bailouts for dying paper mills, but since there is an upper bound for what can be tolerated, there must be some optimal value at which the tradeoff between the costs of volatility and the costs of restraining price adjustment is balanced. I do not know where this is, but I suspect it is not a corner solution.

I mean, the dollar moved four cents yesterday. FOUR. 1.085->1.10->1.075. (Admittedly, the Chinese don't grow bored of mahjongg every night and decide to buy some Canadian dollars.) How many economists of yesteryear would have believed the sheer magnitudes of the currency moves we've seen recently? Probably not a ton. I'm fairly sure someone said we needed more superlatives to accurately describe the situation. I'm inclined to agree.

I mean, Bretton-Woods isn't the answer. But I suspect something will give before we see ten-cent swings in the value of the dollar in a 24-hour period. Maybe that something is a central role for stabilizing currency.

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