Gavin Davies has a very interesting post in his blog on the FT wherein he references a 1999 paper by Ben Bernanke(Japanese Monetary Policy:A Case of Self-Induced Paralysis http://www.pile.com/publications/chapters_previews/319/7iie289X.pdf) for the Peterson Institute for International Economics on the deflationary plight of Japan and a strategy for escaping the liquidity trap.

He apparently got a reference to the paper from Joseph Belbruno who often comments in a very insightful and Keynesian fashion in the FT. Bernanke conducts an insightful thought experiment with respect to Japanese monetary policy and its capacity to devalue its currency by increasing its money stock. At one point in the paper he argues that it must be the case that increasing Japan’s money supply will inevitably lead to inflation and a cheaper currency against the currency of others because otherwise increasing the domestic currency supply would enable Japan to buy up all the world’s assets simply by increasing its currency supply.

Undoubtedly there is some element of truth in this fiat money anti neo mercantilist argument. But countries do not operate in a vacuum. What counts is relative prices particularly with respect to international trade and foreign investment. The more money that a country say Japan used to purchase the assets of another country the more of that currency that recipient country would have and the more it could purchase the assets of other countries including Japan. In addition if in response to this aggressive move by one country other countries could equally increase their money stocks. In the end although nominal prices might well rise, though not in a one to one way as we know from our knowledge of the liquidity trap, relative prices might remain unchanged.

The end result would also depend upon the degree of unused capacity that existed in each country’s economy, the degree of oligopoly and type of economic structure including the presence of trade unions that prevailed before we could easily predict the outcome.

In the current global environment a full decade later we still have considerable unused capacity, differential monetary and fiscal policy across the international spectrum and the complications of the carry trade to consider in this kind of thought experiment. If countries that face high unemployment insist upon tight monetary and fiscal policy while their trading partners strive through more flexible policy to stimulate their own economy the result is likely to be a reduction in total global growth below what would have prevailed if policies were more uniformly stimulative.

The resulting exchange rates are probably indeterminate since tight money will raise the rate whereas stimulative policy with lower rates might drop it but lower unemployment and faster growth will raise it. Finally factor endowments of precious resources like oil, gas and energy generally will generally raise it depending on global circumstances. For example, a fall in global energy prices results in a fall in the value  of the Canadian dollar against that of the U.S.