Russia’s economic challenges

Russia’s economy is in trouble. Growth has come to a halt. A recession looms in 2015. Inflation, interest rates, and capital flight are up. The government’s budget is under strain. More than any of these, what makes the headlines is the plunge of the ruble, which, at one point in mid-December, had lost half of its value against the dollar in less than a year. What lies behind the weakness of the ruble? Is it harmful in itself, or is it better understood as a symptom of other problems? What options are open to Russian policymakers as they struggle to manage their currency’s descent?

Accounting for inflation

As in many discussions of macroeconomics, we first need to deal with the effects of inflation. Economists use the term nominal to refer to quantities stated in the ordinary way and real to quantities that are adjusted to for inflation. Real wages are the most familiar example: We all understand that if our boss raises our nominal wage from $10 per hour to $12 per hour, but at the same time inflation adds 20 percent to the price of everything we buy, our true purchasing power has not changed.

A similar principle applies to exchange rates. Other things being equal, a change in the nominal exchange rate of the ruble would mean change in the competitiveness of goods the country produces for export and those it produces for sale at home in competition with imports. However, inflation also has an impact on competitiveness – one that can either amplify or offset changes in the nominal exchange rate.

For example, a nominal depreciation of the ruble from 20 rubles per dollar to 25 per dollar would, by itself, make it easier for Russian exporters of steel and wood products to compete in world markets. At the same time, if would make it easier for Russian farmers and automakers to compete with imports. On the other hand, inflation that raised prices and wages within the ruble economy would undermine competitiveness of Russian exporters and import-competitors, even if the nominal exchange rate were unchanged. If the nominal exchange rate depreciated at exactly the rate of inflation, competitive relations would remain unchanged. The ruble price of wood or steel exported from Russia would rise, but the dollar price to foreign buyers would not change. On Russia’s internal market, depreciation of the ruble would drive the ruble prices of imported cars and butter up at the same rate that inflation raised up the prices of their domestic competitors.

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Author: Edwin G. Dolan holds a Ph.D. in economics from Yale University and has taught global macroeconomics, managerial economics, money and banking, and other courses at several universities in Europe.

Image: A general view shows the Moscow International Business Center and the Mercury City Tower in Moscow, November 1, 2012. REUTERS/Sergei Karpukhin.