ECONOMICS U$A
EXCHANGE RATES
To show the effect of exchange rates on trade and domestic growth and inflation, and the effect of domestic economic events of foreign exchange rates.
OBJECTIVES:
1. If the value of the dollar compared to other currencies increases, goods exported from the U.S. will cost more in terms of foreign currencies than before, and imports will cost less than before. Therefore, net exports will tend to fall, depressing economic growth in the U.S., and stimulating growth overseas.
2. A country’s ability to import and export changes over time because of underlying changes in relative wage rates, productivity, technology, etc. When such long-term changes occur, either the exchange rates have to be realigned or the country which has lost its competitive ability will have to endure a long period of slow growth in order to restore the trade balance.
3. The following will tend to cause the dollar to fall vis-à-vis foreign currencies:
a) a higher real growth rate in the U.S. (because it will cause net exports to fall)
b) a higher inflation rate in the U.S. (because people will want to hold currencies that are not depreciating)
c) a lower interest rate in the U.S. (because people will convert their dollars to foreign currencies to earn high interest)
d) pessimism regarding the relative value of investments opportunities in the U.S.
The converse of these effects will cause the dollar to rise.
KEY ECONOMIC CONCEPTS:
government intervention in currency markets, economic activity, inflation, interest rates, and exchange rates, gold standard, balance of payment, deficit or surplus,
flexible exchange rates,
purchasing power parity
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Contemporary Issues Exchange Rates In the three years after the launch of the euro (Europe’s new single currency) in January 1999, it lost close to a third of its value against the dollar. Many European leaders were embarrassed by the weakness of the fledgling currency and hoped that it would strengthen. They got their wish. Between January 2002 and the summer of 2003, the euro regained all the ground that it had lost against the dollar. However, the stronger currency was a mixed blessing. In 2003, many of the key European economies (including Germany) were in or close to being in a recession. A stronger euro only hurt them, by making European exports more expensive. Is a strong or a weak currency inherently good or bad? Under what circumstances might a strong or a weak currency be beneficial for an economy? |
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| Gold Standard For generations, exchange rates were fixed and currencies convertible to gold. But in 1925, the British Parliament set the exchange rate of the pound for gold beyond it’s real value. As a result British goods became expensive, causing exports to decline, workers to be laid off, and the economy to unravel. England went off the gold standard and devalued the pound, sacrificing international status for domestic recovery. This caused European banks, which had been holding pounds, to lose millions. President Hoover however, proclaimed America’s steadfastness to the gold standard. International investors rushed to withdraw their dollars in exchange for gold. In order to entice foreign investors to keep their money in US banks the Federal Reserve raised the rate of interest. The British began exporting more and importing less, causing the US market to be flooded with British goods. This decreased the price of agricultural products for the farmers of the US and a decrease in exports. This forced more jobs to be lost and America was driven further into an economic depression. Although Hoover maintained a policy adhering to the gold standard, his successor FDR abandoned the god standard. The result: US exports became cheaper, more jobs were created. Comment and Analysis by Richard Gill The gold standard was cherished historically for two reasons. By giving each national currency a fixed value in terms of gold, it gave the world, a single common currently. Second it provided a mechanism for keeping every nation’s balance of payments in balance. However in 1930 countries were not willing to go through this adjustment process, so the gold standard collapsed.
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| Bretton Woods In July 1944, world economic leaders met in Bretton Woods, New Hampshire to create for blueprint for a New World economic order. The goals were to get monetary stability without the rigidity of the gold standard and to prevent a recurrence of the deflation and the depression that followed WWI and to promote world trade that would benefit all nations. To insure stability the Bretton Woods Agreements outlined a system of international cooperation where the American dollar was convertible to gold. Bretton Woods provided a framework for rebuilding Europe. The US played the key role in financing Europe’s recovery. The Marshall Plan, created in 1947 gave millions of dollars to Europe. The American economy reaped immediate benefits from Europe’s rebuilding. By the mid-fifties European economies were no longer so dependent upon American goods. Where before there had been an international shortage, now the world faced a dollar glut causing banks to redeem dollars for American gold, causing a large drop in US gold reserves. The US pressured foreign central banks to retain their dollars but to little avail. When Nixon assumed the Presidency, he broke from the Bretton Woods Agreement. He suspended the convertibility of the dollar into gold or other reserve assets except in those that were in America’s interest. This ushered in the era of floating exchange rates, where one countries currency was able to float against the currenciens of other nations in response to the pressures of supply and demand. Comment and Analysis by Richard Gill The Bretton Woods experience suggests that when supply and demand pressures get too great, a fixed exchange rate system, has a tendency to buckle. |
| The Euro On January 1, 2002, twelve members of the European Union accepted a common currency called the Euro. It called upon each nation to abandon their individual currencies and tie their economic future to the Euro. What this did, was to put the economy of the EU nations on the same international scale as that of the US. The Euro would now equal the dollar as the major world currency standard. Many analysts thought this was more of a significant political event that an economic one. Others thought that it would finally bring about a United States of Europe and an economicx challenge to the United States. But there is a risk. No longer will each member be in control of its own economy. Since there is a commom currency, there must also be a common interest rate and no member will be able to alter its own monetary policy to effectuate a change in inflation or employment. So far, the experiment has met with considerable success. But then no one can predict the future. Comment and Analysis by Nariman Behravesh The introduction of the Euro was a momentous event. And on the upside forced many profligate countries, like Italy, to cleanup their act. Initially, the value of the Euro in relationship to the dollar fell almost 30 percent. But in 2002-3 it has rebounded dramatically. Nonetheless, many economic analysts think that the powers that be at the new European Central Bank have set interest rates too high and as a result have hurt economic growth. Particularly in a country like Germany. For the time being, however, the likelihood of the Euro replacing the dollar as the world's most desirable currency is far from coming about. |