Chapter 21 - Trade Policy, Protectionism, and Currency Manipulation

Abstract

A commonly held assumption is that changes in the nominal exchange rate alter an economy’s terms of trade and as such by manipulating the exchange rate a country can affect changes in its trade balance. Devaluations are one extreme and presumably a “one time” application of this view. While currency manipulation is considered the continuous application of a policy aimed to alter a country’s terms of trade and thus trade balance through a deliberate exchange rate manipulation. Elsewhere, we have shown that the equivalence between the terms of trade and exchange rates depends on the organization of the monetary system and whether the monetary authorities can affect changes in the economy’s relative prices. Price rigidities is one of the sufficient conditions that allow the monetary authorities to impact the relative prices through the exchange rate manipulation and or devaluation. In that case, the domestic prices will not adjust as the exchange rate varies thereby altering the price of domestic goods relative to the rest of the world goods. However, if the domestic prices are flexible, under some general conditions, we can show there is the possibility that the domestic prices can adjust and thereby negate the effect of the exchange rate manipulation. Thus the issue of the effectiveness of a currency manipulation policy depends on the degree of price flexibility, that is the ability of the prices to adjust to offset the changes in the exchange rate. In other words, the issue is an empirical one that the data can either validate or reject. However, the nominal exchange rate alone is not enough to test, prove, or disprove the underlying hypothesis. The countries’ price levels must also be included to calculate the terms of trade or real exchange rate and then one can test for the possibility that a devaluation may affect the terms of trade. Our analysis of the Chinese economy suggests that over longer period of time, the prices are flexible enough to offset any impact that a currency manipulation scheme may have on the terms of trade. We find no evidence that the Chinese are effective currency manipulators.