The Exchange Rate as a Monetary Phenomenon


What exactly is an exchange rate?

We all know that one of the main challenges in the study of international finance is the setting of exchange rates. But Barnard College Prof. Perry Mehrling, who also is a member of the Institute for New Economic Thinking’s Curriculum Committee, attempts to answer this more basic question by putting forward a new way of thinking about this “thing” called an exchange rate [Essential hybridity: A money view of FX].

For Mehrling, the exchange rate is determined in the moment when one state confronts another state and two financial systems meet. Thus, the foreign exchange market has a hybrid aspect that is overlooked by the standard academic perspective where economics and finance are seen as distrinct from political science and the legal system.

But what Mehrling calls “the money view” embraces both market and state aspects of the exchange rate. For Mehrling, the key to bridging this divide is “to conceptualize the exchange rate as the price of one money in terms of another money; [with] money itself being essentially a hybrid entity part market and part state.”

This hybrid nature becomes clear in the distinction between “state” money and “private” money. Currency, or state money, is considered legal tender and is issued by the state. Meanwhile, private profit-seeking entities create the private money by issuing payment obligations in one or another currency.

The important element of hybridity in practice is that inside a particular currency area the par exchange between state money and private money keeps an equivalence of quantity between these two qualitatively different kinds of money. Central banks are the force behind keeping the rate between state money and private money at par. By understanding the exchange rate through Mehrling’s lens, one sees that exchange rates retain quantitative equivalence between what are in fact disparate kinds of money.

To understand the practice of setting exchange rates, let’s look at two extreme scenarios.

In one extreme, a central bank, acting on behalf of a government, sets the exchange rate as a matter of policy. In the other, a central bank lets the exchange rate be completely determined by the profit-seeking private dealers. Today’s exchange rate system is a hybrid sitting somewhere between these two extremes; private dealers are responsible for most of the day-to-day trading, whereas central banks play the role of the “dealer of the last resort” in the forex market.

The key to comprehending how the exchange rate is determined is in the relationship between the profit-seeking forex dealer and the central bank. In this context, central banks are viewed as a special kind of forex dealer that pursues stability rather than profit.

The conventional economics view of the forex market is to regard the exchange rate as the relative price of the tradable goods, while finance understands the exchange rate as the relative price of the tradable assets. Neither sees the market as a trade in money. Rather, exchange is understood as a kind of barter that abstracts from money.

By contrast, what Mehrling labels “the money view” takes the “reserves constraint” on the end-of-day clearing in a multilateral payments system seriously. Mehrling applies Minksy’s survival constraint to the international exchange of money by examining the means through which deficit countries must settle with surplus countries.

Nowadays, deficit countries have to acquire dollars in the global forex market to settle their debts. The key point in the” money view” is to understand how the requirement to obtain dollars shapes the behavior of the deficit country. Different types of dealers must participate in the market to provide it with enough dollars to meet its obligations.

In Mehrling’s view, the international monetary system constitutes a hierarchy, the dollar being on top of the hierarchy and other currencies below it. The public dollar functions as money and all other non-dollar currencies can be regarded as a kind of credit with implicit promises to pay dollars. Integrating major and minor currencies into the picture, “the money view” presents a relationship where minor currencies are promises to pay with major currencies, and major currencies are promises to pay with dollars, which are the ultimate world reserve currency.

From this perspective, the starting point for analysis is always Minsky’s survival constraint, which highlights the need for all financial entities to settle payment each day. Central banks that handle overnight interest rates come into the picture as foreign exchange dealers of last resort.

It is worth emphasizing, though, that the central bank of a deficit country is not in an equivalent position as the central bank for a surplus country. The deficit county faces the survival constraint at clearing and therefore is obliged to intervene in the supply of its own currency once the private dealer is not willing to participate in the market anymore. In this way, it is actually acting as speculative dealer of last resort. Of course, the critical difference between the central bank and the private dealer, however, is that the central bank is not a profit seeking entity. Thus, it can take positions to improve the liquidity of its currency even at a “loss.”

In the end, Mehrling’s point of view provides a framework to see exchange rates as what they actually are: a market in money that has to be viewed as a hybrid between private and state actors. His paper is important because it provides an opening to incorporate the actual mechanics of foreign exchange and the interests of public and private entities in this market. This is beyond an issue of finance. Rather, it is a legal and political phenomenon.

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