CHAPTER 3

Foreign Exchange Market, Currency Future and Option Market

1. History of Foreign Exchange Market

The system used for exchanging foreign currencies has evolved from the gold

standard, to an agreement on fixed exchange rates, to a floating rate system.

1.1 Gold Standard

From 1876 to 1913, exchange rates were dictated by the gold standard.

Each currency was convertible into gold at a specified rate.

When World War I began in 1914, the gold standard was suspended. Some

countries reverted to the gold standard in the 1920s but abandoned it as a

result of a banking panic in the United States and Europe during the Great

Depression.

In the 1930s, some countries attempted to peg their currency to the dollar

or the British pound, but there were frequent revisions.

1.2 Agreements on Fixed Exchange Rates

In 1944, an international agreement (known as the Bretton Woods

Agreement) called for fixed exchange rates between currencies.

By 1971, the U.S. dollar appeared to be overvalued; the foreign demand for

U.S. dollars was substantially less than the supply of dollars for sale (to be

exchanged for other currencies)

1.3 Floating Exchange Rate System

By March 1973, the official boundaries imposed by the Smithsonian

Agreement were eliminated. The widely traded currencies were allowed to

fluctuate in accordance with market forces.

2. Foreign Exchange Transaction

2.1 Spot Market

The most common type of foreign exchange transaction is for immediate

exchange. The market where these transactions occur is known as the spot

market. The exchange rate at which one currency is traded for another in

the spot market is known as the spot rate.

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2.2 Spot Market Structure

Commercial transactions in the spot market are often done electronically,

and the exchange rate at the time determines the amount of funds necessary

for the transaction.

2.3 Use of the Dollar in the Spot Market

- The U.S. dollar is commonly accepted as a medium of exchange by

merchants in many countries, especially in countries such as Bolivia,

Indonesia, Russia, and Vietnam where the home currency may be weak or

subject to foreign exchange restrictions.

2.4 Spot Market Time Zones

- Although foreign exchange trading is conducted only during normal

business hours in a given location, these hours vary among locations due to

different time zones. Thus, at any given time on a weekday, somewhere

around the world a bank is open and ready to accommodate foreign

exchange requests.

2.5 Spot Market Liquidity

- The spot market for each currency can be described by its liquidity, which

reflects the level of trading activity. The more buyers and sellers there are,

the more liquid a market is.

2.6 Attributes of Banks That Provide Foreign Exchange

The following characteristics of banks are important to customers in need of

foreign exchange:

2.6.1 Competitiveness of quote. A savings of l¢ per unit on an order of 1 million

units of currency is worth $10,000.

2.6.2 Special relationship with the bank. The bank may offer cash management

services or be willing to make a special effort to obtain even hard-to-find

foreign currencies for the corporation.

2.6.3 Speed of execution. Banks may vary in the efficiency with which they

handle an order. A corporation needing the currency will prefer a bank that

conducts the transaction promptly and handles any paperwork properly.

2.6.4 Advice about current market conditions. Some banks may provide

assessments of foreign economies and relevant activities in the

international financial environment that relate to corporate customers.

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2.6.5 Forecasting advice. Some banks may provide forecasts of the future state

of foreign economies and the future value of exchange rates.

3. Foreign Exchange Quotations

3.1 Bid/Ask Spread of Banks

- Commercial banks charge fees for conducting foreign exchange

transactions; they buy currencies from customers at a slightly lower price

than the price at which they sell the currencies. At any given point in time,

a bank’s bid (buy) quote for a foreign currency will be less than its ask

(sell) quote.

3.2 Comparison of Bid/Ask Spread among Currencies

- The differential between a bid quote and an ask quote will look much

smaller for currencies that have a smaller value. This differential can be

standardized by measuring it as a percentage of the currency’s spot rate.

3.3 Factors That Affect the Spread

The spread on currency quotations is influenced by the following factors:

- Order costs. Order costs are the costs of processing orders, including

clearing costs and the costs of recording transactions.

- Inventory costs. Inventory costs are the costs of maintaining an inventory

of a particular currency. Holding an inventory involves an opportunity cost

because the funds could have been used for some other purpose. If interest

rates are relatively high, the opportunity cost of holding an inventory

should be relatively high. The higher the inventory costs, the larger the

spread that will be established to cover these costs.

- Competition. The more intense the competition, the smaller the spread

quoted by intermediaries. Competition is more intense for the more widely

traded currencies because there is more business in those currencies.

- Volume. More liquid currencies are less likely to experience a sudden

change in price. Currencies that have a large trading volume are more

liquid because there are numerous buyers and sellers at any given time.

This means that the market has sufficient depth that a few large

transactions are unlikely to cause the currency’s price to change abruptly.

- Currency risk. Some currencies exhibit more volatility than others because

of economic or political conditions that cause the demand for and supply of

the currency to change abruptly. For example, currencies in countries that

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have frequent political crises are subject to abrupt price movements.

Intermediaries that are willing to buy or sell these currencies could incur

large losses due to an abrupt change in the values of these currencies.

4. Interpreting Foreign Exchange Quotations

4.1 Direct versus Indirect Quotations

Quotations that represent the value of a foreign currency in dollars (number of

dollars per currency) are referred to as direct quotations. Conversely, quotations

that represent the number of units of a foreign currency per dollar are referred to as

indirect quotations. The indirect quotation is the reciprocal of the corresponding

direct quotation.

4.2 Interpreting Changes in Exchange Rates

If you are doing an extensive analysis of exchange rates, convert all exchange rates

into direct quotations. In this way, you can more easily compare currencies and are

less likely to make a mistake in determining whether a currency is appreciating or

depreciating over a particular period.

4.3 Source of Exchange Rate Quotations

Trends are available for various periods, such as 1 day, 5 days, 1 month, 3 months,

6 months, 1 year, and 5 years. As you review a trend of exchange rates, be aware

of whether the exchange rate quotation is direct (value in dollars) or indirect

(number of currency per dollar) so that you can properly interpret the trend.

4.4 Cross Exchange Rates

Most tables of exchange rate quotations express currencies relative to the dollar,

but in some instances, a firm will be concerned about the exchange rate between

two non-dollar currencies.

4.5 Source of Cross Exchange Rate Quotations

View the recent trend of a particular cross exchange rate for periods such as 1 day,

5 days, 1 month, 3 months, or 1 year. The trend indicates the volatility of a cross

exchange rate over a particular period. Two non-dollar currencies may exhibit high

volatility against the U.S. dollar, but if their movements are very highly correlated

against the dollar, the cross exchange rate between these currencies would be

relatively stable over time.

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4.6 Currency Derivative

A currency derivative is a contract with a price that is partially derived from the

value of the underlying currency that it represents.

4.7 Forward Contracts

In some cases, an MNC may prefer to lock in an exchange rate at which it can

obtain a currency for a future point in time. A forward contract is an agreement

between an MNC and a foreign exchange dealer that specifies the currencies to be

exchanged, the exchange rate, and the date at which the transaction will occur.

4.8 Currency Options Contracts

Currency options contracts can be classified as calls or puts. A currency call option

provides the right to buy a specific currency at a specific price (called the strike

price or exercise price) within a specific period of time. It is used to hedge future

payables. A currency put option provides the right to sell a specific currency at a

specific price within a specific period of time. It is used to hedge future

receivables.

INTERNATIONAL MONEY MARKET

5. Origins and Development

5.1 European Money Market

The origins of the European money market can be traced to the Eurocurrency

market that developed during the 1960s and 1970s. As MNCs expanded their

operations during that period, international financial intermediation emerged to

accommodate their needs.

5.2 Asian Money Market

Like the European money market, the Asian money market originated as a market

involving mostly dollar-denominated deposits, and was originally known as the

Asian dollar market.

6. Money Market Interest Rates among Currencies

6.1 Global Integration of Money Market Interest Rates

When economic conditions weaken in many countries, the corporate need for

liquidity declines, and corporations reduce the amount of shortterm funds they

wish to borrow. Thus, the aggregate demand for short-term funds declines in many

countries, and money market interest rates decline as well in those countries.

Conversely, when economic conditions strengthen in many countries, there is an

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increase in corporate expansion, and corporations need additional liquidity to

support their expansion.

6.2 Risk of International Money Market Securities

The debt securities issued by MNCs and government agencies with a short-term

maturity (1 year or less) within the international money market are referred to as

international money market securities.

7. International Credit Market

The international credit market is well developed in Asia and is developing in South

America. Periodically, some regions are affected by an economic crisis, which

increases the credit risk. Financial institutions tend to reduce their participation in

those markets when credit risk increases. Thus, even though funding is widely

available in many markets, the funds tend to move toward the markets where

economic conditions are strong and credit risk is tolerable.

8. Regulations in the Credit Market

8.1 Single European Act

One of the most significant events affecting international banking was the Single

European Act, which was phased in by 1992 throughout the European Union (EU)

countries. The following are some of the more relevant provisions of the Single

European Act for the banking industry:

- Capital can flow freely throughout Europe.

- Banks can offer a wide variety of lending, leasing, and securities activities

in the EU.

- Regulations regarding competition, mergers, and taxes are similar

throughout the EU.

- A bank established in any one of the EU countries has the right to expand

into any or all of the other EU countries.

8.2 Basel Accord

Before 1987, capital standards imposed on banks varied across countries, which

allowed some banks to have a comparative global advantage over others when

extending their loans to MNCs in other countries.

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8.3 Basel II Accord

Banking regulators that form the so-called Basel Committee are completing a new

accord (called Basel II) to correct some inconsistencies that still exist. For

example, banks in some countries have required better collateral to back their

loans. The Basel II Accord attempts to account for such differences among banks.

8.4 Basel III Accord

The financial crisis in 2008–2009 illustrated how banks were still highly exposed

to risk, many banks might have failed without government funding.

9. Syndicated Loans in the Credit Market

Sometimes a single bank is unwilling or unable to lend the amount needed by a

particular corporation or government agency. In this case, a syndicate of banks may be

organized. Each bank within the syndicate participates in the lending. A lead bank is

responsible for negotiating terms with the borrower. Then the lead bank organizes a

group of banks to underwrite the loans.

10. Impact of the Credit Crisis on the Credit Market

In 2008, the United States experienced a credit crisis that was triggered by the

substantial defaults on so-called subprime (lower quality) mortgages. This led to a halt

in housing development, which reduced income, spending, and jobs.

11. International Bond Market

The international bond market facilitates the flow of funds between borrowers who

need long-term funds and investors who are willing to supply long-term funds. Within

a given country, local borrowers that issue bonds at a given time may pay different

yields. Normally, the national government pays a lower yield than other corporations

on bonds issued within a country because the bonds issued by the national government

are perceived to have no default risk, or less default risk than bonds issued by

corporations.

12. Eurobond Market

12.1 Features of Eurobonds

Eurobonds have several distinctive features. They are usually issued in bearer

form, which means that there are no records kept regarding ownership

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12.2 Denominations

Eurobonds are commonly denominated in a number of currencies. Although

the U.S. dollar is used most often, denominating 70 to 75 percent of

Eurobonds, the euro will likely also be used to a significant extent in the

future.

12.3 Underwriting Process

Eurobonds are underwritten by a multinational syndicate of investment banks

and simultaneously placed in many countries, providing a wide spectrum of

fund sources to tap. The underwriting process takes place in a sequence of

steps. The multinational managing syndicate sells the bonds to a large

underwriting crew.

12.4 Secondary Market

Eurobonds also have a secondary market. The market makers are in many

cases the same underwriters who sell the primary issues. A technological

advance called Euro-clear helps to inform all traders about outstanding issues

for sale, thus allowing a more active secondary market.

12.5 Impact of the Euro on the Eurobond Market

Before the adoption of the euro in much of Europe, MNCs in European

countries commonly preferred to issue bonds in their own local currency. The

market for bonds in each currency was limited.

13. Development of Other Bond Markets

13.1 Global Integration of Bond Yields

Bond market yields among countries tend to be highly correlated over time

because interest rates across countries are correlated, and interest rates

influence the yields offered on bonds.

14. Risk of International Bonds

14.1 Credit Risk

The credit risk of international bonds represents the potential for default,

whereby interest or principal payments to investors are suspended temporarily

or permanently.

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14.2 Interest Rate Risk

The interest rate risk of international bonds represents the potential for the

value of bonds to decline in response to rising long-term interest rates. When

long-term interest rates rise, the required rate of return by investors rises.

14.3 Exchange Rate Risk

Exchange rate risk represents the potential for the value of bonds to decline

(from the investor’s perspective) because the currency denominating the bond

depreciates against the home currency of the investor.

14.4 Liquidity Risk

Liquidity risk represents the potential for the value of bonds to decline at the

time they are for sale because there is not a consistently active market for the

bonds. Thus, investors who wish to sell the bonds may need to lower the price

in order to sell them.

15. How Financial Markets Serve MNCs

The first function is foreign trade with business clients. Exports generate foreign cash

inflows, while imports require cash outflows. A second function is direct foreign

investment, or the acquisition of foreign real assets. This function requires cash

outflows but generates future inflows through remitted earnings back to the MNC

parent or the sale of these foreign assets. A third function is short-term investment or

financing in foreign securities. A fourth function is longer-term financing in the

international bond or stock markets. An MNC’s parent may use international money or

bond markets to obtain funds at a lower cost than they can be obtained locally.

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CASES

BLADES, INC. CASE

1. One point of concern for you is that there is a trade-off between the higher interest

rates in Thailand and the delayed conversion of baht into dollars. Explain what this

means.

ANSWER: If the net baht-denominated cash flows are converted into pounds today,

Blades is not subject to any future depreciation of the baht that would result in less

pound cash flows.

2. If the net baht received from the Thailand operation are invested in Thailand, how will

UK operations be affected? (Assume that Blades is currently paying 10 percent on

dollars borrowed, and needs more financing for its firm.)

ANSWER: If the cash flows generated in Thailand are all used to support UK

operations, then Blades will have to borrow additional funds in the UK (or the

international money market) at an interest rate of 10 percent. For example, if the baht

will depreciate by 10 percent over the next year, the Thai investment will render a

yield of roughly 5 percent, while the company pays 10 percent interest on funds

borrowed in the UK Since the funds could have been converted into pounds

immediately and used in the UK, the baht should probably be converted into pounds

today to forgo the additional (expected) interest expenses that would be incurred from

this action.

3. Construct a spreadsheet to compare the cash flows resulting from two plans. Under the

first plan, net baht-denominated cash flows (received today) will be invested in

Thailand at 15 percent for a one-year period, after which the baht will be converted to

dollars. The expected spot rate for the baht in one year is about £0.0147 (Ben Holt’s

plan). Under the second plan, net baht-denominated cash flows are converted to

pounds immediately and invested in the United Kingdom for one year at 8 percent. For

this question, assume that all baht-denominated cash flows are due today. Does Holt’s

plan seem superior in terms of pound cash flows available after one year? Compare

the choice of investing the funds versus using the funds to provide needed financing to

the firm.

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ANSWER: If Blades can borrow funds at an interest rate below 8 percent, it should

invest the excess funds generated in Thailand at 8 percent and borrow funds at the

lower interest rate. If, however, Blades can borrow funds at an interest rate above 8

percent (as is currently the case with an interest rate of 10 percent), Blades should use

the excess funds generated in Thailand to support its operations rather than borrowing.

Plan 1–Ben Holt's Plan

Calculation of baht-denominated revenue:

Price per pair of "Speedos" 4,594

× Pairs of "Speedos" 180,000

= Baht-denominated revenue 826,920,000

Calculation of baht-denominated cost of goods sold:

Cost of goods sold per pair of "Speedos" 2,871

× Pairs of "Speedos" 72,000

= Baht-denominated expenses 206,712,000

Calculation of dollar receipts due to conversion of baht into dollars:

Net baht-denominated cash flows now

(826,920,000 – 206,712,000) 620,208,000

Interest earned on baht over a one-year period (15%) 93,031,200

Baht to be converted in one year 713,239,200

× Expected spot rate of baht in one year £ 0.0147

= Expected dollar receipts in one year £10,484,616

Plan 2—Immediate Conversion

Calculation of baht-denominated revenue:

Price per pair of "Speedos" 4,594

× Pairs of "Speedos" 180,000

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= Baht-denominated revenue 826,920,000

Calculation of baht-denominated cost of goods sold:

Cost of goods sold per pair of "Speedos" 2,871

× Pairs of "Speedos" 72,000

= Baht-denominated expenses 206,712,000

Calculation of dollar receipts due to conversion of baht into dollars:

Net baht-denominated cash flows to be converted (826,920,000 –

206,712,000) 620,208,000

× Spot rate of baht now £ 0.016

= Dollar receipts now £ 9,923,328

Interest earned on pounds over a one-year period (8%) 793,866

= Dollar receipts in one year £ 10,717,194

Calculation of pound difference between the two plans:

Plan 1 £ 10,484,616

Plan 2 £ 10,717,194

Dollar difference £ (232,578)

Thus, the cash flow generated in one year by Plan 1 is very close to Plan 2,

Plan 2 is slightly better.

SMALL BUSINESS DILEMMA Case

1. Explain how the Sports Exports Company could utilize the spot market to facilitate the

exchange of currencies. Be specific.

ANSWER: The Sports Exports Company would have an account with a commercial

bank. As it receives payment in pounds each month, it would deposit the check at a

bank that provides foreign exchange services. Each month, the bank would cash the

check, and then convert the British pounds received into euros for the Sports Exports

Company at the prevailing spot rate.

2. Explain how the Sports Exports Company is exposed to exchange rate risk and how it

could use the forward market to hedge this risk.

ANSWER: The Sports Exports Company is exposed to exchange rate risk, because the

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value of the British pound will change over time. If the pound depreciates over time,

the payment in pounds will convert to fewer euros. The Sports Exports Company

could engage in a forward contract in which it would sell pounds forward in exchange

for euros. For example, if it anticipated receiving a payment in pounds 30 days from

now, it could negotiate a forward contract in which it would sell pounds in exchange

for euros at a specific forward rate. This would lock in the forward rate at which the

pounds would be converted into euros in 30 days, thereby removing any concern that

the pound could depreciate against the euro over that 30-day period. This hedges

exchange rate risk over the short run, but does not effectively hedge against exchange

rate risk over the long run.

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CHAPTER 4

International Parity Conditions and Currency Forecasting

I. ARBITRAGE AND THE LAW OF ONE PRICE

- Five Parity Conditions Result From Arbitrage Activities :

1. Purchasing Power Parity (PPP)

2. The Fisher Effect (FE)

3. The International Fisher Effect (IFE)

4. Interest Rate Parity (IRP)

5. Unbiased Forward Rate (UFR)

- Inflation and home currency depreciation are:

1. jointly determined by the growth of domestic money supply (Ms) and

2. relative to the growth of domestic money demand (MD).

II. PURCHASING POWER PARITY

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Inflation

Changes in Exchange

rates

Changes in Interest

rates

PPP FE

Changes in Forward

RatesIRPUFR

IFE

1. THE THEORY OF PURCHASING POWER PARITY

States that spot exchange rates between currencies will change to the differential in

inflation rates between countries.

- Purchasing Power Parity Conditions :

In order to exist PPP we assume:

All goods and services are tradable

Transportation and other Trading costs are zero

Consumers in all countries consume the same proportions of goods and

services

The LAW OF ONE PRICE prevails

II. THE LAW OF ONE PRICE

A. Law states:

Identical goods sell for the same price worldwide.

B. Theoretical basis:

If the price after exchange-rate adjustment was not equal, arbitrage worldwide

ensures that eventually it will.

C. Absolute Purchasing Power Parity

III. RELATIVE PURCHASING POWER PARITY

A. states that the exchange rate of one currency against another will adjust to

reflect changes in the price levels of the two countries.

1. In mathematical terms:

et

eo

=(1+ih )t

(1+i f )t

where et = future spot rate

e0 = spot rate

ih = home inflation expected

if = foreign inflation exp

t = time period

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2. If purchasing power parity is expected to hold, then the best prediction for the

one period spot rate should be

e t=e0

(1+ih )t

(1+if ) t

3. A more simplified but less precise relationship is

et−e0

e0

=ih−if

that is, the percentage change in rates should be approximately equal to the

inflation rate differential

4. PPP says

the currency with the higher inflation rate is expected to depreciate relative to

the currency with the lower rate of inflation.

Sample Problem :

Projected inflation rates for the U.S. and Germany for the next twelve months are 10% and

4%, respectively. If the current exchange rate is $.50/dm, what should the future spot rate be

at the end of next twelve months?

e t=e0

(1+ih )t

(1+if ) t = e t=0,50(1,10 )1

(1,04 )1

e1=0,50(1,0577) = e1=$ 0,529

III. THE FISHER EFFECT

1. THE FISHER EFFECT

states that nominal interest rates (r) are a function of the real interest rate (a)

and a premium (i) for inflation expectations. R = a + i

IV. THE INTERNATIONAL FISHER EFFECT

A. Real Rates of Interest

1. Should tend toward equality everywhere through arbitrage.

2. With no government interference nominal rates vary by inflation

differential or rh - rf = ih - if

B. According to the IFE, countries with higher expected inflation rates

have higher interest rates.

2. IFE STATES:16

A. the spot rate adjusts to the interest rate differential between two

countries.

B. IFE = PPP + FE

et

eo

=(1+ih )t

(1+i f )t

C. Fisher postulated

1. The nominal interest rate differential should reflect the

inflation rate differential.

D. Simplified IFE equation:

rh−rf =et−eo

eo

E. Implications if IFE is at work:

1. Currency with the lower interest rate expected to appreciate relative

to one with a higher rate.

If the ¥/$ spot rate is ¥108/$ and the interest rates in Tokyo and

New York are 6% and 12%, respectively, what is the future spot

rate two years from now?

e t=e0

(1+ih )t

(1+if ) t = e2=108(1,06 )2

(1,12 )2

e2=108(1,1236 )(1,2544 )

= e2=¥ 96,74 /$

V. INTEREST RATE PARITY THEORY

I. INTRODUCTION

A. The Theory states:

the forward rate (F) differs from the spot rate (S) at equilibrium by an

amount equal to the interest differential (rh - rf) between two countries.

B. The forward premium or discount equals the interest rate differential.

(F – S)/S = (rh - rf)

where rh = the home rate

rf = the foreign rate

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F = the forward rate

S = the spot rate

C. In equilibrium, returns on currencies will be the same

i. e. No profit will be realized and interest rate parity exists which can be

written

FS

=(1+rh )(1+r f )

D. Covered Interest Arbitrage

1. Conditions required: interest rate differential does not equal the forward premium or

discount.

2. Funds will move to a country with a more attractive rate.

3. Market pressures develop:

a. As one currency is more demanded spot and sold forward.

b. Inflow of funds depresses interest rates.

c. Parity eventually reached.

CASES

President Carter Lectures The Foreign Exchange Markets - Mini-Case

1. How were financial markets likely to respond to President Carter's lecture? Explain.

ANSWER.

Skeptically. Markets are in fact marvelously efficient systems for collecting

and assessing information, and as such their judgments are not stupid but smart.

Time and again markets have demonstrated their ability to outwit Wall Street

hotshots, central bankers, economic advisers, and especially politicians.

2. At the time President Carter made his remarks, the inflation rate was running at about

10% annually and accelerating as the Federal Reserve continued to pump up the money

supply to finance the growing government budget deficit. Meanwhile, the interest rate on

long-term Treasury bonds had risen to about 8.5%. Was President Carter correct in his

assessment of the positive effects on the dollar of the higher interest rates? Explain. Note

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that during 1977, the movement of private capital had switched to an outflow of $6.6

billion in the second half of the year, from an inflow of $2.9 billion in the first half.

ANSWER.

Interest rates were high because the market was expecting continued high

inflation owing to rapid growth of the U.S. money supply. As such, the

international Fisher effect tells us that the high U.S. interest rate was forecasting

depreciation of the dollar, not appreciation. If these high nominal rates actually

indicated high real rates, then money should have been flowing into the United

States, not out of it as was happening.

3. Comment on the consequences of a reduction in U.S. oil imports for the value of the U.S.

dollar. Next, consider that President Carter's energy policy involved heavily taxing U.S.

oil production, imposing price controls on domestically produced crude oil and gasoline,

and providing rebates to users of heating oil. How was this energy policy likely to affect

the value of the dollar?

ANSWER.

Oil imports were slowing down because U.S. economic growth was slowing

down. According to the asset-market model of exchange rate determination, this

made the U.S. a less attractive place to invest money in and put downward pressure

on the dollar. Cutting oil imports by slowing down economic growth is equivalent

to burning down the barn to get rid of the mice. If President Carter really wanted to

pursue sensible economic policies that would lead to fewer oil imports, he should

have offered up an energy program that increased incentives for domestic oil

production and for domestic energy conservation. Instead, his policies taxed

domestic production and subsidized domestic consumption. The resulting distortion

in investment and consumption patterns reduced U.S. economic efficiency and

caused the dollar to decline.

4. What were the likely consequences of the slowdown in U.S. economic growth for the

value of the dollar? the U.S. trade balance?

ANSWER.

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Chapter 2 showed that healthy economies have strong currencies and sick

economies have weak currencies. Rapidly growing economies use more of the

world's resources, and this shows up in the trade figures as a larger trade deficit.

But this does not normally lead to a depreciation of the growing economy's

currency. Normally what happens is that a growing economy attracts investment

and foreign capital, which offsets the larger trade deficit. The result is a stronger

currency, not a weaker one. This theory was borne out in the early 1980s when the

rapid growth of the U.S. economy resulted in a large trade deficit and a soaring

dollar.

5. If President Carter had listened to the financial markets, instead of trying to lecture them,

what might he have heard? That is, what were the markets trying to tell him about his

policies?

ANSWER.

The flight from the dollar was a massive vote by the financial markets of no

confidence in the Carter Administration's economic policies. The markets were telling

him that they thought his policies were inflationary and anti-growth. Dollar-denominated

assets were marked down because the markets saw that the dollar's value was eroding

both at home and in relation to other currencies abroad. At the same time that the

inflation rate was declining in Germany, Japan, and even the U.K., it was accelerating in

the United States. Yet the Federal Reserve was continuing to pump reserves into the

banking system, leading to expectations of higher inflation down the road. Simply put,

the dollar was not declining because the U.S. was importing too much oil or growing too

fast; the dollar was declining because too many dollars were being printed and because

the world had lost confidence in the Carter Administration's economic policies. The

markets were clearly telling him it was time for a change in his policies. By October

1979, the message had gotten loud enough that President Carter's newly appointed

chairman of the Federal Reserve Board, Paul Volcker, instituted a new monetary policy

that dramatically slowed down the growth of the U.S. money supply. But it was not until

Ronald Reagan became president that the United States instituted pro-growth economic

policies--in the form of big tax cuts and a reduction in the anti-business policies and

rhetoric so common under Jimmy Carter.

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