Thursday, February 9, 2012
Productivity and Exchange Rates
Let's assume we have a nation "A" with a policy of free floating ("FF") and non-convertible state currency; and likewise we have a nation "B" with the same currency policy.
In A the private economy solely consists of one factory that makes devices called apads, and in B it is the same again, the private economy solely consists of one factory that also makes apads. Both of these factories operate on the quota principle where the workers are required to work 8 hours a day and assemble 8 apads during this time, if you don't make 8 they call in Donald Trump and a NBC moron reality show camera crew and.... you guessed it: "You're fired!!". Each worker receives 1 unit of the state currency for each day they work and assemble the 8 apads. Let's assume this 1 currency unit (labor costs) are the only input cost to either process in both countries.
Productivity is a measure of the efficiency of production. Productivity is a ratio of production (output) to what is required to produce it (inputs). In our fictitious 2 nations, input is the cost of labor which is 1 currency unit per day per employee, and the output in real terms is 8 apads per day per employee.
There is trade in apads between each country and it is settled in the local currency.
Nation A has very well educated and skilled workers who are always "innovating" while they work, they take pride in their work and feel exceptionally blessed to be productive citizens of nation A. One day one of the apad assemblers in nation A comes up with some new "innovation" that enables all the workers to now produce 9 apads per day in the same 8 hours, and everyone is very proud and happy as as this represents a 12.5% productivity improvement!!! Now they can show nation B who is better and more productive!
Unbeknown to those in nation A, while all of their "innovating" was going on, the authorities in nation B become enamored with the currency of nation A for seemingly irrational reasons, and become zealous to obtain it, they have dreams at night about controlling huge balances of the nation A currency. They walk in to the apad factory in the morning and demand that the workers now produce 12 apads per day, even if it takes them 12 hours to produce them and they will only be paid the same 1 currency unit of nation B currency and if they don't comply: cue The Donald. The authorities in nation B think: "Now we can show nation A who is better and more productive AND we will be able to sell more apads to nation A to obtain larger balances of that wonderful nation A currency we have been dreaming about !"
What now happens to the exchange rate of the nation A currency to the nation B currency?
(Hint?: If you work in nation A, the moment your policy makers decided to go with "FF" you got "effed".)