EC103-Topic #4: Exchange Rates

This week, the dollar hit a new record low against the Euro currency. Additionally, the Federal Reserve may again decide to cut the Federal Funds target interest rate this week, possibly weakening the dollar even further (The Federal Funds rate is the rate that banks loan to one another which impacts many other lending rates in U.S. markets). However, the Federal Reserve may not cut rates due to the increased pressure this places on the economy.

Additionally, the Chinese currency (Renminbi) has recently gained strength versus the dollar despite the fact that the Chinese central bank has increased interest rates dramatically in recent months. If the Federal Reserve decides to cut interest rates this Wednesday (10/31) the currencies I have mentioned here and in class will likely move even further. Inflation is under control for the most part in the United States, but other countries may be having issues with rising prices. Interest rate movements among trading partners have significant impacts on exchange rates and inflation across borders. I would like you to discuss these recent changes in the context of the “prevent recession at any costs” mentality of the U.S. central bank.

Questions you might try to answer:

  • What are the implications of a predicted interest rate cut by the U.S. Federal Reserve?
  • Why does the Federal Reserve decide to ‘leak’ information on their prospective interest rate decisions?
  • If the Chinese, Euro, and/or Canadian currencies continue to appreciate against the U.S. dollar, what should happen to the U.S. trade deficit?
  • Can you cite some recent evidence for the change or narrowing in the U.S. trade deficit?
  • Cite and discuss someone who agrees with a Federal Reserve rate cut.
  • Cite and discuss someone who disagrees with a Federal Reserve rate cut.

Remember… I would like your statements to be as subjective as possible, or in jargon terms, positive and not normative in nature. Also, remember, I want you to keep your descriptions short, basic, and related to classroom content. Read other students comments before posting, and please leave your name with your posting.

20 thoughts on “EC103-Topic #4: Exchange Rates”

  1. In an article published on June 10, 2007 in the International Herald Tribune, Jeremy Peters discusses the importance of trade for the U.S. economy. With economic growth increasing at a much slower pace, trade will play a vital role in the growth and help aid in ridding the U.S. of their significant trade deficit. He later stated, “In real terms, the deficit for the first four months of the year fell by 3 percent compared with the period last year.” The weaker dollar overseas will help aid the U.S. in reducing this trade deficit by boosting its exports. Also the U.S. is currently importing fewer goods to help balance their economy. The U.S. faces their hugest deficit with China. Economists estimate about a third of the deficit comes from China. This means the increased strength of Chinese currency to the dollar will hopefully aid in reducing the imbalance of trade by increasing exports. Source:Peter, W. Jeremy. International Herald Tribune. “Narrowing U.S. trade deficit may lift economic growth.”

  2. Kristen said…So i think that the crisis that we are going through right now is very interesting. When reading the articles that were posted on the website, i realized that i never completely understood what all these terms meant. I am curious to see what the FEDs do in response to the declining rate of the US dollar compared to the Euro. I think that people are not investing money as much money as they should into the united states economy, becuase we are in the middle of fighting a war. I think that poeple are starting to realize that this war is taking a large toll on our economy. (do you think that this is the reason that interest rates are going up? becuase the government needs to collect more money to help fund the war.. becuase people are starting to not believe in fighting) I think that this is a very interesting issue and it will be interesting to see if the FEDs decide to cut interest rates again, to see if people will respond to this cut.

  3. As the value of foreign currencies increase, their countries can buy more U.S. exports, which is good for our economy. As their products become more expensive to us because of the currency exchange rate, we could either buy less of their exports and encourage U.S. consumers to buy domestically, or if the goods are a necessity we would have to spend more on these foreign products. If we can buy alternative goods domestically, this could actually help our current trade deficit.While lower interest rates can help expand our economy, it may also encourage investors to transfer their funds to other countries where their deposits and fixed-income investments can bring them higher returns, which could weaken our currency. A weakening of our currency could cause a recession as a result of the decrease of money supply in our banks and a decrease in investment.Policy maker & San Francisco Fed President Janet Yellen cites the economy’s ability to survive financial turmoil in the past as a reason to avoid overreacting to the latest market problems, and that rate cuts by the Fed will keep our economy up & running without falling into a recession. For example, in 1998, stocks slumped & credit costs rose after the collapse of LTCM. In reaction to this, the Fed quickly cut rates three times, resulting in a 6.2 percent growth in the economy in the fourth quarter.

  4. The Federal Reserve’s decision to cut interest rates again is not being universally acclaimed. In fact, some think that it might be cause for one of the worst recessions in the last 25 years.Robert P. Murphy, author of The Politically Incorrect Guide to Capitalism, said “Not only will [the rate cut] pave the way for much higher price inflation than Americans have seen in decades, but it will also exacerbate what could be the worst recession in twenty-five years.” [Read the article here: claims that an alternative view of the business cycle, the Australian Business Cycle Theory, shows that the Fed’s insistence on cutting rates may delay the recession, but in the end, it will only make it worse. Jim Rogers, an investment mogul and chairman of Beeland Interests Inc., agreed. He said, “[Ben Bernanke] is a nut. The dollar is collapsing, commodities are going through the roof, which means inflation’s going through the roof. These people are leading us to terrible problems down the line.” [Read the article here: Both these thinkers seem to believe that the Federal Reserve is leading the United States down a bad path by cutting interest rates twice in the last two months.

  5. In reducing the interest rate this past week, the Federal Reserve intends to “jump-start the economy.” However, doing so can have a negative impact on other, more global macro issues. While cutting rates stimulates a greater volume of production and consumption it simultaneously weakens domestic currency. This is because “investors transfer funds to countries where their deposits and fixed income investments bring higher returns” (CNN money).Conversely, the Fed may heighten interest rates to prevent an extreme peak in the business cycle. “Higher rates can boost a currency” and, in turn, it is expected that output will decline when interest rates are high.There is, then, an inverse relationship between interest rates and a country’s output; but this we knew already. What this infers, however, is that when an economy is preventing a recession with cuts in domestic interest rates, production increases heavily and at lower costs. Simultaneously, the purchasing power of foreign currencies strengthens. Together, these forces significantly reduce the cost of domestic goods to foreigners. This will spark an increase in exports and relieve some of the economic stress, proving the efforts of the Federal Reserve rewarding and constructive.

  6. The circular flow of income consists of four separate markets, and a change in one market causes a ripple effect in each other one. When the Federal Reserve decides to change the United States interest-rate, it must factor in how it will affect the goods and services, resources, and foreign exchange markets. A cut in the interest-rate would reduce the cost of borrowing money, and cause demand of goods and services to shift to the right, which in turn causes greater demand for resources. The effect it can have on the foreign exchange market is a depreciation of the dollar, thus making it less attractive for foreign markets to borrow from the United States.In contrast to the United States, China’s currency has appreciated and the nation has raised the interest rate five times this year to ward off inflation. If currencies such as the euro or the renminbi continue to appreciate over the U.S. dollar, the trade deficit of the United States would most likely turn into a surplus. The reason is that because the foreign currency would gain more value over the dollar, foreign markets could buy more goods from the United States while U.S. imports would decline.

  7. In terms of U.S. exports, an interest rate cut can be helpful because it weakens the U.S. dollar and it makes our goods cheaper to buy for foreign countries. In the current situation, where the U.S. dollar is significantly weaker than the euro, our exports may be increasing, but it is harming other countries who use the euro. This decrease in interest rates can also be harmful to the U.S. economy because, as the CNN Money article, “Dollar hits record low against euro,” states, it weakens the dollar so much so that investors tend to transfer funds to countries where their investments will bring them higher returns. I understand the difficult job the Fed has in choosing whether to cut or raise interest rates. However, continuing to let the dollar depreciate may have more harmful repercussions than helpful ones. Considering the Fed is reluctant to cut rates because of recent cuts, as noted in the article, “Bernanke, ‘Reluctant’ to Cut Rates, May End Up Doing So Anyway,” it would seem that slowly increasing interest rates could serve to help the economy. The possibility of more investors transferring their money elsewhere doesn’t seem to bode well for the economy and perhaps the Fed should be more worried about this possibility.

  8. The recent cut in the interest rates has been predicted to prevent further tightening of consumer credit and make it slightly easier for homeowners to refinance their mortgages and home equity loans. As the dollar depreciates, and the Chinese, Euro, and/or Canadian currencies appreciate, the price of American goods become cheaper, whereas the price of foreign good become more expensive. This could lead to an increase in our exports and a decrease in our imports; which in turn could end up helping our trade deficit. Though this is good, having a trade deficit is not necessarily a bad thing. Trade deficits indicate an inflow of capital which is always good for an economy. In addition, in the past couple weeks the American dollar has depreciated so much that it is almost now equal to the Canadian dollar (nicknamed the loonie). This means that foreign investors from countries such as Germany and Japan now may see Canada as a better and more stable place to invest their money. The appreciation of the loonie will cause a boost in the Canadian economy. Though consumers have not yet seen the most recent effects of the appreciating loonie, it is believed that these effects will soon trickle down to the consumers. The recent soar in the Canadian dollar reflects “strong fundamentals of the Canadian economy, which has benefited from record world crude oil prices and strong demand for metals, coal, chemicals and grain. (Dan Richman and Claudia Rowe, Seattle Post-Intelligencer).” At the same time, the US economy has been hurting due to the collapse in the housing market and the worsening of the credit crunch.

  9. As previously stated, the increasesd currency rates of other countries can prove to be positive for our economy in a sense. As a country we can promote U.S spending which could possibly make up for the fact of decreased imports. However, with these increased values in foreign currencies, we focus on our trade deficit.With the deppreciation of the U.S. Dollar, we can be sure that there will be a boost in U.S exports. Other countries will increase their U.S spending and will have more of a want for U.S goods. In a sense although the U.S Dollar is decreasing, we can expect that more money will becoming in that other countires will be purchasing our goods.

  10. The implications of a predicted interest rate cut by the Fed Reserve my lower the value of the American dollar compared to other countries. This causes U.S. citizens to purchase domestic products instead of expensive foreign products due to the decrease in currency. If the Chinese, Euro, and/or Canadian currency continues to appreciate, the U.S. will consider purchasing more of their goods domestically.The Federal Reserve decides to “leak” information on their prospective interest rate decisions in order to not surprise the market. If a sudden change in interest rates occurs it can lead to inflation. Therefore, the Federal Reserve leaks the information in order for the market to anticipate the effects of the change in interest rate.”With all the subprime and credit issues, it looks like there will be more problems to come. Combine that with the backdrop of weaker economic growth and my guess is that the Fed will cut rates again,” said Phil Dow, director of equity strategy with RBC Dain Rauscher. Dow believes that if the Fed continues to cut the rates, there will be more problems in the long run. It may discourage investors to invest in domestic business and take their money to foreign nations and receive higher returns. However, Phil Orlando, chief equity market strategist at Federated Investors, states “We don’t think the economy’s about to slip into recession… However, should the Fed choose not to cut anymore, and the economy continue to slip, that potentially could raise some concerns for us.” Orlando believes that rate cuts are necessary for the economy to strive. Arielle’s example is also proof that rate cuts have worked in the past and it may be possible for the cuts to work again.

  11. Lowering interest rate or not is a challenging decision that the Federal Reserve have to make. Under the circumstance that the dollar hit a record low against the Euro currency, the actual inflation rate remains constant in the short run causes a reduction in the real interest rate, and consequently stimulates investment and consumption. Reduction in interest rate stimulates foreigners to invest elsewhere where interest rate is higher, which causes lower demand for dollar hence weakening the dollar. For the US market, the cost of buying US good is cheaper so it will benefit US exports. Consequently, trade deficit should converge. The solution for this is to weaken the dollar even further. The ultimate goal is to stimulate aggregate demand, prevent the recent financial turmoil from drastically affecting the broader economy and renew market tumult, rise oil prices and falling home values which drive the U.S. economy into recession. However, the Fed still hesitate to make up the decision because lowering interest rate may help boost up economy and then sub-prime crisis but it also may lead to higher inflation. The Fed tried to avoid a similar situation last month with its half-point cut, says Laurence Meyer, a Fed governor from 1996 to 2002 and now vice chairman of Macroeconomic Advisers LLC of St. Louis. Instead, it once again faces calls for another cut. Although the Fed is still reluctant to give out the final decision, they leak the information about the trend to lower the interest rate for the market (stock market) and investors adjust and are less affected by the surprise. Its goal would be to dissuade investors from anticipating a series of reductions, an outlook that could further weaken the dollar and revive inflation concerns.Sources sited:http://econblog.aplia.com

  12. As the U.S. dollar moves farther and farther away from other currencies such as the euro and the renminbi, foreign powers will buy more American goods. This is because it will be cheaper for them to buy our products. While American investors may put more money overseas this is unlikely. The reason many countries move their investment to the United States is because they have faith in the American economy. Investors here also have faith in the U.S. dollar. The Federal Reserve is transparent for a reason. Unlike other countries that do not tell their citizens what they are doing, in the hopes of tricking them, the US Federal Reserve tells the public what it plans to do with respect to interest rates. This allows businesses to expect changes, and act accordingly. Since the economy is very effected by small changes, the Federal Reserve hopes that by cutting interest rates people will corperations will buy more money, adding more productivity to the U.S. work force. The Federal Reserve will have to decide whether it is more important to prevent the dollar’s value from falling or strengthening the U.S. production.

  13. If Federal Reserve decides to cut the Federal Funds target interest rate again, I do not think it is a good idea. “Although lower interest rates can jump-start [American] economy,” It can weaken the currency as well. Right now Canadian, Chinese, and European currencies keep appreciating over the U.S. dollar. As the important trade partners of America, “American investors transfer funds to these countries where their deposits and fixed-income investments bring higher returns.” The weakening dollar will increase the American exports and decrease the imports. The trade deficit decreases right away. It leads the lower capital inflow into America which means investors are pessimistic about American economy. So I believe cutting the Federal Funds target interest rate again give more disadvantages to the economy in the future.

  14. Lower interest rates would be good and bad for the US economy, for one the trade deficit would decrease due to a decrease in the USD worth. Which would make goods more affordable to other countries, and increase our exports. However imports would also get more expensive, if appreciation of other countries currencies continues to gain against the USD, which would make it harder for people to afford certain goods.Another issue with China’s Yuan gaining power toward the dollar is that most of our imports come from China, due partially to their cheap prices. If their prices continue to rise we will not be able to afford what we are currently buying, which could hurt our economy by forcing the US to spend more on imports.Lower interest rates may help jump start the economy, or it could end up leading us in to a recession. By making it more desirable for people deposit their money into foreign currencies that have a larger chance of increasing against the dollar. This would be bad because it means that we would be taking are money out of our banks and giving it to other countries. Which will lower the amount of money in our banks that takes away from loans and spending by the banks and government.

  15. The Federal Reserve cutting interest rate below their target interest rate might not be a good idea. It weakening the value of the dollar and it decreases its purchasing power. Now, consumers need to pay to purchase the same item that they purchased before. But while their purchasing power goes down, their incomes haven’t increase. It makes the consumers to cut down their consumptions. Also when interest rate is low, the investors would move their investments to other countries that they can yield a higher return. It reduces the capital inflows from flowing into the US. While the Federal Reserve cutes the interest rate and weakening the dollar, the Chinese currency and the euros raise steadily and strengthening their purchasing power. It makes the US goods cheaper to buy to the foreigners and help to increase its exports. It decreases trade deficit. Also as the Chinese currency and euros raise, the debt that the US owe China and other euros use countries goes down as well. Qi Qin Tan

  16. The cut in interest rates is going to encourage buying in the US, but at the same time, the devaluation of the dollar compared to foreign currency is going make foreign goods more expensive to American consumers. Production of American goods should begin to increase as these goods are demanded more by both American and foreign consumers.China, as our largest trade partner, will certainly be affected. As we learned in class, they seem to be making efforts to maintain the current trade state. If a dollar can’t buy as many Chinese goods, will China make an effort to either make either better or cheaper products to maintain the current level of trade? If so, any devaluation of the dollar will be dampened, perhaps to the point that the trade deficit may not decrease. However, our total output will have increased as American goods flow into other markets. The only effect many Americans may feel is a general increase in our own economy.

  17. In response to the Fed’s decision to again lower interest rates, Congressman Ron Paul spoke out against the “inflationary monetary policy,” specifically regarding its impact on “hard-working Americans” and “retirees.”Paul does not overlook the fact that this policy will help to reduce our trade deficit, however he feels that the domestic issues that arise from the diminished purchasing power outweigh these international benefits.Contrary to Paul’s argument, a rate cut that occurred roughly one month prior to his statement resulted in a dramatic boost in the stock market, and investors were generally happy with the decision. For now, I believe that the trend of slowly decreasing rates should be continued and the international value of the dollar should be carefully monitored. It is clear that adjustments can have serious positive and negative implications, however careful monitoring and adjustments will lower the risk of both recession and over-inflation.Source:Press Release – Statement on Federal Reserve Rate Cut. October 31, 2007.

  18. By leaking out information about prospective interest rate decisions, the Federal Reserve can control how people spend. If they are revealing that they may decrease interest rates in the near future, people may wait to take out a loan. Conversely, if they tell people that an increase in interest rates is soon to come, people will rush to borrow money at the current, lower interest rate.If foreign currencies continue to appreciate against the United States dollar, the US trade deficit will most likely narrow, as the lower prices for foreign countries to import American goods will be an incentive for them to do so. As we begin to export more goods and import less, our trade deficit will decrease.According to an article by Philip Brewer, it is to keep ” the federal funds rate stable, [thus] avoiding the “moral hazard” of bailing out people who made risky investments.” I agree with his statement, that cutting the Federal Funds rate may cause individuals to borrow too much money at the lower interest rate and decide to make risky investments. However, I also believe that the US deficit has grown too much, in part due to high gas prices, and that a weakening of the US dollar may not be such a bad thing.

  19. NICHOLAS CINQUINO-The concept of preventing a recession to occur by any means possible seems logical but in reality it is a poor decision. For a US citizen unaware of economic theory this may seem like a good plan, but in reality we must undergo the highs and lows of the complete business cycle. By lowering interest rates there is an increase in consumer want to buy. This stimulates the economy. The weakening of the US dollar also promotes economic growth as it increases the want of foreign countries to buy our goods. This will decrease our trade deficit and further reduce our debt. In reality, these significant changes only skim the surface in solving economic problems. These are the quick and easy solutions to the prospect of recession. With examination of macroeconomic theory these are not most beneficial solutions. Ideally, we would suffer through a recession. This would cause the stirring up of our population and force some individuals into new job markets or even send some individuals back to school for specialization and education in other areas. This would cause better long term matches and in time produce economic growth. As long as our country has this extreme fear of recession we will not be able to grow economically to our potential. What needs to be realized is that sometimes in order to take a big leap forward a small step backward must be taken first!

  20. The implications of a predicted interest rate cut by the U.S. Federal Reserve is short-term slowdown in the loan able fund market. This is because borrowers would want to wait for the interest rates to go down, so they could save a bit of money, before they take out a loan. If the Fed does lower the rate the there will be an increase in the number borrowers seeking credit because it would be cheaper to borrow money. However, it would decrease the number of foreigners willing to extend credit in the US because they would not be able to get as high a return. The Fed leaks information on their prospective interest rate decisions to see how the market will react. If the market reacts positively to the prospect of the cut then the Fed will probably go through with it, but if the Fed gets a negative reaction they will probably not. If foreign currencies continue to appreciate against the dollar then the US trade deficit should fall. This is because it will become more expensive for US companies to import good from abroad, as it would require more dollars to trade for the foreign currency. It would also boost exports because it would be cheaper for foreign firms to buy goods in US dollars.

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