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D ep reci ati on
Do exchange depreciations tend to
exacerbate domestic inflation? If so,
what does this imply about national
exchange-rate policies and the
functioning of the international
monetary system?
Since 1973, major currencies have
been floating against one anothersome (such as the European
"snake" currencies) tied together
in a currency bloc, and others floating separately. Many observers
question whether the floating
exchange-rate system might have
contributed to the inflationary
pressures in the world economy.
For an individual country attempting to combat domestic inflation,
this is a critical consideration whenever it decides to adjust the value of
its currency or to let it float.

Two cases
For example, Mexico last August
abandoned the fixed parity of 12.5
pesos per dollar which had been
maintained for more than 22 years.
At first, the rate dropped to about
20 pesos, and in late October it
dropped further to more than 25
pesos per dollar. Thus, in less than
two months, the peso lost more
than 50 percent of its former value.
Some Mexican merchants reacted
by doubling or even tripling prices,
and labor unions in turn demanded

I n fl ati on ?
a 60-percent rise in wages to compensate for the price increases.The
general impression was one of
massivedepreciation contributing
to massive inflation.
Great Britain provides another example. Becausethat nation has suffered significantly higher inflation
than other major industrial countries, sterling has taken a severe
beating in the exchange markets in
recent years. From about $2.02 at
the end of 1975, it sank 20 percent
to only $1.60 by late October 1976.
It has since recovered to more than
$1.70,as the U.K. accepted International Monetary Fund conditions
involved in the provision of multibillion dollar credits through the
Fund. This support from major. industrial countries (and also from
private commercial banks) was felt
necessaryin order to give the U. K.
time to put its house in order, and
on the ground that further depreciation would only create more
inflation and increase the Government's difficulties in achieving its
domestic stabilization objectives.
To many observers, the common
thread running through these and
other similar casesis the tendency
for exchange depreciation to aggravate domestic inflationary pressures.Thus, other things being

(continued

on page 2)

Opinions expressed in this nev\!sletter do not
necessarily reflect the views of the management of the
Federal Reserve Bank of San Francisco! nor of the Board
of Covernors of the Federal Reserve System.

equal, the maintenance of a stable

with causes.Both exchange depie-

exchange rate would tend to support domestic stabilization goals.

ciation and domestic price inflation
are symptoms of excess demand for
goods and services; they are not
interrelated causes.

Vicious circle
How reasonable is that conclusion?
One might argue that, since depreciation makes imports more expensive in terms of domestic currency,
it will necessarily add to inflationary
pressure at home. Moreover, since
domestic inflation is often the underlying cause of exchange depreciation, and exchange depreciation
produces more inflation, the analysis apparently points to a "vicious
circle" of mutual causality, which
could plunge a national economy
into a disastrous tail-spin if unchecked by "appropriate"
stabilization-policy measures.
If this vicious-circle theory is correct, depreciation will be selfdefeating and destabilizing to the
national economy. The theory is
particularly attractive to policy
makers whose political instincts favor the avoidance of abrupt policy
changes. Rightly or wrongly, policymakers and the general public still
attach considerable stigma to exchange depreciation, which is often
equated to official admission of
policy failure.

CausesliS symptoms
Yet in arguing that inflation begets
depreciation and depreciation begets more inflation, the viciouscircle theory confuses symptoms

Consider first the case of floating
exchange rates. An excess demand
for domestically produced goods
causes a rise in domestic pricesand for foreign goods, a depreciation of the national currency. An
excess demand for both will cause
both domestically-produced goods
prices to rise and the exchange to
depreciate.
Thus, depreciation means higher
domestic prices of foreign goods
and depending on the extent to
which foreign goods enter the nation's consumption stream, a rise in
the domestic inflation rate. After
all, the domestic price of a foreign
good is by definition equal to its
foreign price times the exchange
rate of the national currency. Depreciation, therefore, must mean a
higher domestic price of the foreign good. But, that is simply a
tautology, not to beconfused with
the vicious-circle theory, which
holds that inflation causes depreciation, and depreciation in turn
causes more inflation. The definitional relationship, on the other
hand, simply states that (given foreign prices) exchange depreciation
implies higher domestic prices of
foreign goods, and vice versa.
Some might still argue that any step
toward depreciation should be resisted, because it implies higher
domestic prices of foreign goods.
Thus, from the point of view of the
policy maker who is intent on
avoiding domestic price increases, a

2

stable exchange rate holds great
appeal. Again the argument tends
to draw a wrong conclusion from a
valid premise. It is true that, with a
given inflationary pressure, the rise
in the domestic price level will be
less under fixed exchange rates
than under floating exchange rates.
But the difference is due not to the
nature of exchange rates, but to the
adjustment mechanisms under the
two exchange-rate regimes.
Escapevalve
Under fixed exchange rates, domestic inflationary pressures are
partly worked off by domestic price
increases, and partly absorbed by
the excessof the nation's imports
over exports. Trade deficits and
domestic price increases are alternative manifestations of domestic
inflationary pressures. With a given
amount of domestic inflationary
pressure, the larger the trade deficit, the smaller the corresponding
price increase will be. The nation is,
in fact, subsidizing its current expenditures at artificially low prices
of both foreign and domestic goods
by borrowing abroad or drawing
down its foreign reserves. Under
such circumstances, trade deficits
serve as an escape valve for relieving domestic inflationary pressures,
and domestic price increaseswill be
less, because part of the inflationary
pressure is "exported" to the rest of
the world.
The major difference between fixed
and flexible exchange rates is,
therefore, the extent to which a
country can temporarily "export"
some of its domestically produced
inflation. Under a flexible
exchange-rate regime, all the inflationary consequences of domestic
3

excessdemand are contained within the national economy. Under a
fixed exchange-rate regime, part of
the inflationary pressure can be
lIexported" through trade deficits.
The latter policy is viable so long as
the country can continue to draw
on its foreign reserves or borrow
abroad. But, before such a recourse
runs out, the escape valve will have
to be turned off by exchange depreciation or letting the currency
float. WithoutJhe escape valve, the
inflationary pressure will be all bottled up inside the national economy, and the domestic inflation rate
will indeed be higher. On the basis
of the sequence of events, the unwary observer is easily led to see
causality and accept the "viciouscircle" theory. But, it is just as logical to attribute the higher inflation
rate to exchange depreciation (or
currency floating) and to put the
blame for the greater steam pressure inside the boiler on the wrench
that is used to turn off the escape
valve.
By refusing to devalue or letting the
currency float, the policymaker is
counting on the rest of the world to
absorb some of the inflation pressures emanating from the country.
So long as the rest of the world is
willing to accommodate; it is a perfectly sensible policy to follow. But
it is a perversion of economic analysis to justify the policy in terms of
the "vicious-circle" theory.

Hang-ShengCheng

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BANKING DATA-TWELfTH FEDERAL SERVE STRUCT
RE
DI
(Dollar amounts in millions)
Amount
Outstanding
5/4/77

SelectedAssets
and liabilities
large CommercialBanks .

Change
from

4127/77

Loans (gross, adjusted) and investments*
Loans (gross, adjusted)-total
Security loans
Commercial and industrial
Real estate
Consumer instalment
U.S. Treasury securities
Other securities
Deposits (less cash items)-total*
Demand deposits (adjusted)
U.S. Government deposits
Time deposits-total*
States and political subdivisions
Savings deposits
Other time deposits:j:
Large negotiable CD's

95,725
73,621
1,750
23,929
22,754
12,838
8)58
13)46
93,701
26,097
555
65,360
5,644
32,071
25,850
9,011

Weekly Averages
of Daily Figures
Member BankReservePosition

Week ended
5/4/77

ExcessReserves (+)l Deficiency
Borrowings
Net free(+)/Net borrowed H

H

+
+
+
+
+
+

-

+
-

-

+
+

-

2
3
5

413
672
183
100
108
71
297
38
2,002
1,634
284
72
2
112
62
147 -

Change from
year ago
Dollar
Percent
+
+
-+
+
+
+

+
+
+

-

+
+

-

7,830
7,654
521
1,535
2,840
1,822
905
1,081
5,385
1,626
67
3,849
1,169
5,932
549
2,280

Week ended

4127/77
+
+

+
+
+
+
+
+

+
+
+

+

+

-

8.91
11.60
42.39
6.85
14.26
16.54
9.37
8.81
6.10
6.64
10.77
6.26
17.16
22.69
2.08
20.19

Comparable
year-ago period

18
11
7

+
+

156
2
154

FederalFunds-Seven large Banks
Interbank Federal fund transactions
Net purchases (+)/Net sales H
Transactions with U.S. security dealers
Net loans (+)/Net borrowings H

424
+

35

- 1,094

353

179

196

+

*Includes items not shown separately. :j:lndividuals, partnerships and corporations.

Editorial commentsmay be addressed the editor (William Burke)or to the author. . ••
to
Information on this and other publications can be obtained by calling or writing the Public
Information Section, Federal ReserveBank of San Francisco,P.O. Box 7702, San Francisco94120.
Phone (415) 544-2184.