The price is right

When it comes to staving off inflation, price can be valuable information.

None of us want to make the mistake one of the mistakes that Sri Lanka recently made concerning foreign exchange.

They have a shortage of it there but, as I’ve said before, this is something that’s impossible with a free market.

It’s only if you try to fix the price of something as Sri Lanka has been trying to do with the value of their rupee that there can be a shortage.

In a market it’s the price that moves until someone is tempted to sell or if others are unwilling to buy.

This is very, very basic economics, so much so that it’s one of those adages which runs either way.

Not only would we say that a price fixing will lead to a shortage, we’d also say that a shortage is evidence of a price fixing.

However, when we look at things like foreign exchange it’s also possible for things to be a little more complex.

For example, the exchange rate of the Bangladeshi taka to the US dollar has been falling just recently. This will indeed be a problem for those who use taka to buy dollars.

But is it a larger problem for the Bangladeshi economy?

The answer is “probably not.” Probably because very few things in economics are absolutely certain. Except, you know, those simple things like shortages being a result of price fixing.

The reason it’s not a problem is that the US dollar has been rising against all currencies this is not something to do with the taka, therefore, is not a reflection of the Bangladeshi economy.

The dollar has been rising against the pound, the euro, and so on.

The reason is that the US central bank, the Federal Reserve, is taking action against their own inflation by increasing interest rates faster and higher than in other countries. 

Traditionally, the long-term determinant of exchange rates is held to be the difference in interest and inflation rates between the ones being considered.

The interest rate is what can be earned in that currency, the inflation rate is what is lost by being in it.

So, the combination of the two gives the earnings.

Over time we’d expect the prices of things to converge so, if the future earnings in one currency change then so does the current price. 

That is the long-term determinant though, many things can intervene in the short term. 

The US has higher inflation than many other countries at present, as the US did more stimulus of the economy than many others and the costs are arriving in that inflation.

So, the Federal Reserve is raising interest rates before other central banks. The effect of this is that the US dollar is rising against other currencies.

Note that it’s not just rising against the taka but near all other currencies.

About the only one rising against the dollar is the ruble and that’s for entirely different, manipulation related, reasons.

So far, this is just trivia. Except that it’s part of an important point.

As Hayek pointed out to us all, we can’t ignore prices because they are information.

Sure we can try to do something to change prices, but we’ve got to understand the information they contain first. 

A generally falling exchange rate can indeed be a sign that something is terribly wrong with economic policy in the nation whose price is falling.

But a fall against just the one currency might not be that it could be that the other currency is rising instead.

If we only look at the bilateral prices we might miss this; we need to look at all prices to discern what’s going on.

Yes, it’s true the taka is falling against the US dollar, but the US dollar is rising against all currencies at present.

It’s not actually a Bangladeshi problem at all but an American one.

They spent too much money in the past and are now paying for having done so with higher interest rates to try and beat inflation.   

Yes, prices are indeed information. But we do have to work out what that information is.

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