The exchange rate instantaneously appreciates (or depreciates) if the current account shifts upward (or downward), and afterwards gradually adjusts to cover the international gap in nominal interest rates. Exchange rate dynamics follow these two rules.
The belief that a currency’s value reflects economic power is consistent with theory so long as full employment is maintained and hence underlying supply-side productivity determines economic power. An increase in productivity expands exports and thereby improves the current account, which appreciates the currency. This improvement in the terms of trade leads to higher real national income. Hence, currency appreciation is evidence of economic power and is accompanied by an increase in national income.
The Yen/Dollar Rate and the Japan-US Gap in Business Activity (1988-2006)
Sources: National Accounts, United Nations Statistics Division; Economic Report of the President, USA.
Current account improvements, however, are not only due to an increase in exports, but also a decrease in imports. The conventional belief only focuses on the former effect. Once unemployment is taken into account, the latter effect comes into play with quite different implications.
Japan suffered from a stock price crash in the early 1990s and people became very pessimistic. They reduced consumption and expanded money holding in preparation for a sudden wage cut or job loss. The demand for imports also decreased and the current account improved, which in turn caused the yen to appreciate. Eventually, both exports and imports decreased and the current account returned to its trend level. Thus, the strong yen was evidence of people’s pessimistic economic outlook and low consumption. It arose together with deflation and decreases in employment and national income.
Evidence given by the figure above is consistent with this argument: the yen appreciates (depreciates) against the US dollar when Japan’s economy stagnates (booms) more than the US economy.
This process is still going on after the worldwide stock market crash of 2008. Reflecting people’s bearishness, Japanese stock prices are weaker than those in the US, and Japan’s economic recovery is very slow. In order to cope with this situation, households keep consumption low while companies downsize employment. These reactions worsen deflation and lower aggregate consumption. Since import demand also decreases, this generates positive pressure on the current account and this causes the yen to appreciate.
Facing this stagnant situation, the Hatoyama government has shifted from supply-side policies to demand-side expansionary policies. Among the various expansionary policy options they emphasize direct transfers to households. Yet, since these transfers must be financed by present or future taxation, total assets do not increase and hence neither aggregate demand nor employment is stimulated. Government purchases and/or public works must be expanded to create new employment and ease deflationary pressures. This will increase imports as well as domestic demand and create negative pressure on the current account, which will cause the yen to depreciate and improve the international competitiveness of Japanese products so that the current account returns to its trend path.
Hatoyama has declared that Japan will cut greenhouse gas emissions 25 per cent below 1990 levels by 2020. This policy is criticised by business groups because it requires additional labour inputs and imposes greater business costs. Nonetheless, this is a conventional logic that holds under full employment. Yet in the presence of unemployment this policy will not only create new labour demand but will also worsen the current account, which will cause the yen to depreciate so much that total employment will eventually be larger.
Japan had a similar experience when Japan’s Clean Air Act, called ‘The Muskie Law’, was implemented in 1978. Business groups claimed that this policy would reduce Japanese exports and harm Japanese automobile industry. In reality, however, the Japanese automobile makers expanded their world market share and boosted the Japanese economy.
Yoshiyasu Ono is professor at the Institute of Social and Economic Research, Osaka University Japan.