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MONETARY POLICY AND IMPLICATIONS FOR CURRENCY DEVALUATION: THE CASE FOR DOLLAR AND GLOBAL ECONOMY

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MONETARY POLICY AND IMPLICATIONS FOR CURRENCY DEVALUATION: THE CASE FOR DOLLAR AND GLOBAL ECONOMY Powered By Docstoc
					                                                     AIB-SE (USA) 2005 Annual Meeting, Charleston, SC



   MONETARY POLICY AND IMPLICATIONS FOR CURRENCY DEVALUATION:
            THE CASE FOR DOLLAR AND GLOBAL ECONOMY

                                Mohamad Sepehri, Jacksonville University


         The focus of this paper is to discuss and examine the implications of monetary policy to devaluate/weaken
the value of dollar and to analyze its impact on National and global trade and economy. Many national and
international economists make solid arguments in favor of weaker dollar against other currencies. In general, a
weaker dollar makes the price of imports cheaper and boosts American exports and, as a result, reducing the US
balance of trade and balance of payments.

         However, in a global economy, any intended policy to change the value of the dollar may
be influenced by the action of the central banks in other countries to keep their currencies weak in relation to the
dollar. Furthermore, any attempt to intentionally lower the value of the dollar may cause unintended harm to US as
well as global economy by causing recession, inflation, and retaliatory action by other US trading partners.



US Monetary Policy in Perspective

         The United States, having the largest economy in the world, significantly impacts the economies of other
nations. United States monetary policy affects economic and financial decisions made by business leaders and
investors. Business purchases, foreign direct investment, and strategic planning are all affected by monetary policy.

         The purpose of the monetary policy is to influence the performance of the economy as related to such
factors as inflation, economic output, and employment. Although exchange rates are affected by many factors,
currency prices are the results of the forces of supply and demand. Supply and demand for any given currency are
influenced by a number of factors which, generally, fall into three categories: (a) economic events, (b) political
conditions, and (c) market psychology.

         During the 1990‟s, the U.S. dollar climbed almost forty percent against the currencies of its largest trading
partners (Paul & Mariana, 2003). The strong dollar attracted overseas money into U.S. stocks, which further added
to Dollar‟s strength. However, after rising against Euro and other major currencies up to most of 2000, the dollar
tumbled five percent against Euro and seven percent against the Yen. This caused the investors and economists to
worry and to wonder if dollar had entered a cycle that would have reversed the gains of the past decade.

         In recent years, many policy makers and many countries have been pushing for and expressing desire for
the dollar to get weaker rather than stronger (Andrews, 2003). However, the recent trends in the rise and the fall of
the dollar, indicates that the debate for strong versus weak dollar may not be resolved anytime soon.


The Arguments for Weak Dollar

         Supporters of allowing the US dollar to devalue against other currencies offer two main potential benefits
(Makin, 2002). First, the price of US-made goods would fall overseas, potentially increasing the demand for US
exports and, at the same time, the falling dollar would make US imports more expensive.

Many US companies receive more than sixty percent of their sales overseas. These companies would all benefit
from a weaker dollar as their stocks become more affordable to foreign investors (Jubak, 2002). Sales of larger
company stocks can often lead investors both home and abroad back into the “market”.




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         Second, the stream of revenue from Foreign Direct Investments mad by US resident companies and
individuals would increase in dollars, increasing their income and potentially their consumption. Both benefits
could help to restore the pace of economic activity, offsetting the recession in recent past.



The Flaws in the Case for Devaluation

    The policies of devaluation, exercised by many nations, have produced limited and mixed degrees of success.
The clear lesson is that the alleged benefits of devaluation are only temporary. The disadvantages can cause
devastating, often long-term harm (Davis, 1998). Any devaluation policy may harm US economy in the following
ways:

        Devaluation tends to increase the prices of imported goods, creating immediate inflation pressures.
        The cost of servicing the National Debt (approximately 25% of it is represented by overseas lenders) will
         increase, putting upward pressure on interest rates.
        The US dollar is the most important currency in the world. A signal for a change to a weaker dollar could
         have a devastating effect on investor confidence. This could prolong the global recession and lead to a
         rapid outflow on investment capital from US (Federal Bank of Chicago, 2004).
        While the potential benefits of devaluation represent opportunities for domestic producers, there is no
         certainty that they will take full advantage of them (West, 2001). Instead of increasing capacity to meet the
         potential increase in export demand and potential substitution for imports, they might simply choose to
         maintain current activity levels and settle for higher pricing. On the other hand, the increase in import
         prices would be inevitable and immediate. Also, the burden of devaluation would fall very much on
         importing businesses, which represent a critical part of the supply chain in today‟s global economy.
        Devaluation only works if other nations allow it. The US‟s major trade partners may respond to US
         dollar‟s devaluation by taking similar action to weaken their currencies. They could also retaliate through
         restrictions on trade, such as tariffs on US goods. Such moves would represent a huge backward step from
         the progress of recent years in abolishing restrictions on international trade (Davis & Cline, 2001).



The Arguments for Strong Dollar

          A strong dollar will trade for more foreign currencies, which helps to lower the prices on imports.
Subsequently, the lower prices in foreign products and services will keep the inflation low (Fed. Reserve, Chicago).
A strong dollar will also encourage more FDI and investment in foreign stocks and bonds and it promote
international travel by US travelers.

         “Strong dollar” policy has also been used by US administration as an indication of strong and stable
economy and a “psychological” tool to boost consumer and investor confidence (O Meara, 2003). Robert Rubin, the
Treasury secretary under President Clinton, has been acknowledged to be the “architect” of the strong-dollar policy.
Since his tenure at the helm of the Treasury Department, all his predecessors (Lawrence Summers, Paul O‟Neill, and
current secretary Snow) have followed his footsteps to officially endorse the strong-dollar policy. However, in
practice and under pressure from businesses and other nations, the administration has welcomed the “actual”
devaluation of the dollar. For example, until recently, as the dollar continued to drop during the past two year, the
US administration/Treasury did not intervene to boost it up and their actions signaled for abandoning the strong-
dollar policy and encouraging the decline of the dollar (Paul and Mariana).

The Flaws in the Case for Strong Dollar

         When dollar is strong, US companies will find it more difficult to compete against foreign imports with
lower prices for comparable products/services. The number of foreign visitors to US will be affected and tourist
destinations like Florida will experience economic losses due to reduced business. The cost of capital, especially for
foreign investors will also increase when dollar increases in value.


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          A strong dollar may not necessarily indicate a strong economy and strong economic fundamentals. For
examples, despite economic downturns in US, the foreign investors have simply preferred US investments because
there are no better investment alternatives available to them. As other large economies have failed to perform any
better that US, the foreign investors perceive the US market as extremely reliable, encountering no particular
political risk or financial uncertainty. Moreover, as dollar continues to be considered the world‟s primary legal
tender and currency, its value tend to remain relatively high and stable.



The Impact of the Lowering the Value of the Dollar

          The influence of the Fed on world currency market is well documented. The world‟s currency markets
reflect supply and demand factors and are constantly shifting. No other market reflects as much of what is going on
in the world at any given time as the foreign exchange market for currency (Volcker, 1995). Although the Fed has
been successful in managing the strength of the dollar, Fed policy has been likened to using a blunt object to
perform a surgical procedure (Santomero, 2002).

         This opinion is related to many factors which impact the value of a country‟s money. They include: (a)
economic policy, (b) political unrest, (c) inflation, (d) budget deficit, (e) trade deficit, and (f) other subjective events.
Economic policy comprises government fiscal policy and monetary policy. Government budget deficits or surpluses
affect economic policy. Devaluation of the dollar as a singular act has unpredictable influences on number of
factors.

          One example of unknown effect of devaluating the dollar is trade. Trade is a measure of the demand for
goods and services, which in turn indicates demand for a country‟s currency to conduct trade (Santomero).
Surpluses and deficits in the trade of goods and services reflect the competitiveness of a nation‟s economy. Trade
deficits may have a negative impact on a nation‟s currency.

          Along with trade deficits, high level of inflation can lower the value of a country‟s currency. Even the
perception of approaching inflation can be enough to erode the purchasing power of – and thus demand for – a
particular country‟s currency. Devaluating the dollar can signal other countries of approaching US inflation. As a
result, foreign nations may sell off dollars, as was the case during the summer of 2002.

          A historical review of the period between 1965 and 1968 gives insight as to the cause-and-effect
relationship of monetary policy and global results. During this three-year period, President Johnson financed the
Viet Nam war and a number of new social programs without increase in taxes. By increasing the money supply,
inflation rose from less than four percent to almost nine percent in 1968. Increased spending on imports, created a
trade imbalance between US and other countries (Hill, 2003).

         Currency markets often move in trends. The price of a currency has a tendency to reflect the impact of a
particular action before it occurs and, once the event passes, react in the opposite direction (Scott, 1999). For
example, the fall of dollar was correctly predicted when the Fed started a round of cuts in US interest rates in recent
years.

         The current US system devalues currencies through interest rate differentials (Santomero). However,
greater precision in currency markets through the use of technology allows market analysts to more accurately
forecast a currency‟s potential devaluation. Once known, interest rate adjustments may make one currency more
valuable than the other currencies, without the need for a revaluation. The appeal of devaluation of currency in the
United States, at the time when the administration has drastically reduced taxes and is maintaining a huge military
presence in a number of countries, may have unintended results.




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Conclusions and Implications

         Devaluation only works if other nations allow it. It is possible that the Euro zone, Japan and the UK would
respond to the US dollar‟s devaluation by taking similar action to weaken Euro, Yen, and Pound Sterling. They
could also retaliate through restrictions on trade, such as tariffs on US goods. The recent pressure from US and
other countries on China to revaluate Yuan is a good example. Such moves would represent a huge backward step
from the progress of recent years in abolishing restrictions on international trade. Ultimately, the key to the dollar‟s
prospects lies less in what the US does than in decisions by central banks in other countries such as Japan, China,
and etc.

          The dollar‟s fall may decrease the healthy international subsidy befitting the US economy for a long time
and, consequently, lowering the standard of living in the US. Concurrently, the drop in demand for imports will
likely harm the global economy and lead to further currency devaluations, trade pressures and financial volatility --
all with potential grave consequences.

          There are many good reasons why the dollar should decline in value against other currencies. As stated
earlier, a weaker dollar will help US exports and will help reduce the balance of trade and balance of payments.
However, the question is how far and how fast the dollar should decline versus the currencies of US trading partners
Gwartney, 2001). When monetary policy is too expansionary, it leads to inflation. Conversely, when it is too
restrictive and results in lower inflation than anticipated, recession follows.

    Predicting the dollar‟s future is not an easy task, given the number of variables currently in the play. For
example:

        The US trade account deficit is more than five percent of US gross domestic product. That level may lead
         to a ten to twenty percent decline in the dollar (Jubak, 2002).
        The US dollar benefits from the political stability of the United States.
        The threat of terrorist attacks may lead to additional withdrawals by overseas investors, with resulting
         declines in dollar.
        Congress may continue spending at record levels. Historically, a budget that supports continued heavy
         deficit spending may have negative impact on the dollar.


Recommendations and Discussion

         It is easy to argue that dollar depreciation would be a simple solution for the United States. However, if the
US government attempts to weaken the US dollar, it would have to address two key questions: (1) by how much and
(2) by means of what specific policy.
Policy can be a blunt instrument, which may fail to bring about the desired effect, or may do so with a greater extend
than intended, and/or bring with it harmful side effects

         Whatever arguments may be advanced in favor of a policy shift towards a weaker dollar, there are major
risks involved. The direction of the US economic policy in recent years has been anti-inflationary and this has been
a major factor in an unprecedented period of economic prosperity. There are always the temptations to devaluate the
currency however, given the current state of US as well as the global economy, such a rationale would be
questionable. Past history has shown that the periods of sustained dollar decline have not been embraced by the
world economy at large. “… By and large, if the overriding objective is price stability, we did better with the
nineteenth century gold standard and passive central banks, with currency boards, or even with „free banking.‟ The
truly unique power of a central bank, after all, is the power to create money, and power to create is the power to
destroy.”
         Devaluation of the dollar was not successful for the US in the 1930‟s and had mixed results in the 1980‟s
and 1990‟s. With the leadership of the US in the international market, devaluation of the dollar would only create
greater economic difficulties for those countries whose currencies are currently pegged to the US dollar ( According
to Federal Reserve, of $680 billion of US currency in circulation in 2003, about $400 billion was held outside the



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                                                     AIB-SE (USA) 2005 Annual Meeting, Charleston, SC


United States). Devaluation of dollar could also weaken consumer confidence and pressure the economy to fall into
a recession.

         History has shown that flexibility of exchange rates in the international market is necessary to respond to
market fluctuations and changes in the domestic economies. A “level playing field” should be established for all
those participating in the membership of the International Monetary Fund (IMF).

        If currency exchange rates were maintained at an equal level with the flexibility to fluctuate at an
acceptable percentage, more pressure would rest on companies to initiate more effective international marketing
techniques to increase demand for their products. Their actions would increase exports, grow the domestic
economy, increase foreign investments, and bring the balance of trade closer to equilibrium.

References
Andrews, Edmund L., New York Times: “Strong Dollar, Weak Dollar: Anyone Have a Scoreboard?” September 24,
2003.

Davies, Anthony, The implications of Currency Devaluation, Cline and Davies Research Alliance, 1998.

Evans, Paul, Wall Street Journal: “Dollar is Expected to Consolidate or Rebound this Week,” May 27, 2002.

Federal Reserve Bank of Chicago, “Strong Dollar, Weak Dollar: Foreign Exchange Rates and the U.S. Economy”,
adapted from “on Reserve”, 1993.

Fuerbringer, J., New York Times: “Weaker Dollar Adds to Potential of Foreign Stocks,” May 26, 2002.

Gwartney, J., Schuler; K. Stein, R. Cato Journal: “Achieving monetary stability at home and abroad,” Volume 21,
Issue 2, pp 183-203, Washington, Fall 2001.

Hill, W. L. and Blake, H. M., International Business. McGraw-Hill, New York, 2003.

Jubak, J. MSNBC: “Don‟t Fear the Dollar‟s Drop Just Yet, “One MSNBC Plaza, New Jersey, May 22, 2002.

King, Stephen, Global Policy forum, “Dollar‟s Weakness is a Concern for Us All,”November 22, 2004.

Makin, John H., The Benefits of Devaluation in a Deflationary World, The American Enterprise Institute, 2000.

Makin, John H., Wall Street Journal: “Charting the Dollar‟s Course,” May 9, 2002.

O‟Meara, Patricia K., GDBC Report: “Strong Dollar Hides Weak Policy,” May 23, 2003.

Parry, John and McCarthy, G., Wall Street Journal: “Dollar Rises Against Counterparts in a Relatively Volatile
Session,” May 8, 2002.

Paul, James A. and Quenemeon, Marianna, global Policy Forum: “Fall of the Dollar,” August 2003.

Phillips, Michael, Wall Street Journal: “Executives Raise Pressure to Weaken U.S. Currency; Secretary Looks to
Markets,” May 2, 2002.

Santomero, A.M., Business Economics: “What Monetary Policy Can and Cannot Do,”Volume 37, Issue 1, pp 15-19,
Washington, January 2002.

Scott, G., Wall Street Journal: “Hidden Devaluation: if it‟s True that History Repeats Itself, Beware of What‟s to
Come in World Markets,” New York, January 1999.




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Santayana, G., The Life of Reason, Charles Scribner‟s Sons, New York, 1905.

Volker, Paul, “Forward”, in M. Deane and R. Pringle, The Central Banks, Viking Penguin, New York, 1995.

West, Andrew, Capitalism: Devaluation is not the Answer, April 11, 2001




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DOCUMENT INFO
Description: The focus of this paper is to discuss and examine the implications of monetary policy to devaluate/weaken the value of dollar and to analyze its impact on National and global trade and economy. Many national and international economists make solid arguments in favor of weaker dollar against other currencies. In general, a weaker dollar makes the price of imports cheaper and boosts American exports and, as a result, reducing the US balance of trade and balance of payments.