The Impact of Falling Dollar in Long Run and Long Run

If the dollar fell, which it could do next year. This would be the economic impact.

• In the short term, a depreciation in the dollar makes exports cheaper and imports more expensive therefore there is a boost to aggregate demand (X-M) Therefore, this boost in exports is likely to improve economic growth.
• However, a depreciation doesn't guarantee long term economic growth. A depreciation does nothing to increase productive capacity. It is a reflection that the economy is becoming less competitive.
• Also a depreciation can cause inflation. This is for 3 reasons.

1. Firstly aggregate demand will increase (potential for excess demand in economy)
2. Secondly, the price of imported goods will be higher. (imported inflation)
3. Thirdly, firms may have less incentive to cut costs.

• Therefore, it is argued a long term depreciation causes the economy to become less competitive.
• A depreciation should help the trade balance. Exports increase faster than imports. However, the impact of a depreciation depends upon
• the elasticity of demand. If demand for exports is inelastic then a cheaper.
• It becomes more difficult to attract foreign capital flows. For example, the US have been financing their National debt by attracting foreigners to buy. But, with dollar depreciating this makes a bad investment. Therefore, it is more difficult to finance national debt. This will lead to either higher interest rates or inflation.

Will Monetary Policy Work

Monetary policy tries to control inflation and economic growth by changing interest rates. However, changing interest rates may be ineffective in influencing economic growth. This is because:

1 Time Lag. It can take upto 18 months for changes in interest rates to effect the economy. This is because people do not make decisions about borrowing straight away. If you have an investment project started you will finish it and not stop just because interest rates have gone up.

2. It depends who you are. E.g. Savers may spend more because they get higher interest payments. However, borrowers will be worse off. If a country has a low savings ratio then higher rates will have a big effect in reducing spending.

3. It depends on other factors affecting the economy. For example, if consumer confidence is very low, higher interest rates may be ineffective in reducing demand.

4. Monetary Policy can only target one thing at a time. For example, if there is cost push inflation, we get higher inflation and lower economic growth. Therefore, monetary policy cannot solve both at once. Supply side hocks make monetary policy quite difficult.

5. The MPC only target inflation therefore they may ignore other problems such as a boom and bust in the housing market.

6. The MPC may have poor information about the state of the economy. e.g. in early 2008 the MPC were predicting high growth and so kept interest rates high. However, growth was much worse than predicted

7. Depends on credibility of monetary policy. If the public have confidence in the Central Bank. If people expect the inflation target to be met, then monetary policy becomes more effective. Arguably, an independent central bank has more credibility than the government.

Why Dollar has been Declining in Value since 2001

The dollar has been falling for various reasons including:

1. Decline in US Competitiveness. US has been losing comparative advantage and becoming more uncompetitive especially in manufacturing industries such as automobile industry. Therefore, there is relatively less demand for the US Dollar.
2. Current Account Deficit. Consumer spending has been rising. This has been financed by a lower savings ratio and higher borrowing. Therefore Americans have increased the demand for imports this causes increased supply of dollars. In recent years it has become more difficult for the US to finance the current account deficit through capital flows. Therefore, the depreciating dollar becomes inevitable. US Current account deficit reached 6.5% GDP in 2006, it is now just under 5%.
3. Investors less willing to buy US Securities. The US was once the strongest economy. But, increasingly people are becoming more sceptical about the state of the US economy - large national debt, subprime mortgage crisis, credit crunch, recession. Also the Euro offers an alternative for Central Banks to hold their foreign reserves.
4. Interest rates in the US have been lower than Europe. Therefore, there is less demand for hot money flows. Because US interest rates are lower.
5. Political Problems make US dollar less attractive. E.g. Iran wants to price oil reserves in Euros.

Why has Dollar has recovered in past few months?

Hedge funds have been selling investments in emerging economies. There is a fear of a meltdown in emerging economies like Hungary, Argentina, India. Therefore, hedge funds have sold these investments and withdrawn money from these vulnerable economies. The result has been an appreciation in the dollar because the investment trusts

• Forecasts for dollar

Bank of England and Inflation

Discuss the relative merits of the Bank of England in controlling inflation

The Bank of England (MPC) are responsible for targeting inflation and using interest rates to achieve the government's target of CPI = 2%

Inflation target is helpful for improving inflation expectations. This is important in keeping inflation low. If people expect low inflation, they will not demand large wage rises and therefore inflation will be lower.

It is important that inflation policy has credibility. Interest rates used to be set by the government, but the government often cut rates for political aims (e.g. boost growth before an election) The Bank of England has avoided this. From 1997-2007, the Bank never allowed the economy to overheat and enter a boom (like the Lawson boom of the 1980s) If the economy grew too quickly they increased interest rates to reduce aggregate demand.

However, the Bank of England has still faced problems in managing the economy.

Because they target inflation, they ignored a boom in house prices. This asset boom and bust has caused problems for the economy (falling house prices in 2008 have caused lower spending)
Also because they only target inflation, some have criticised the Bank for keeping interest rates too high for too long. Arguably, they should have given a greater weighting to economic growth and rising unemployment.

The Bank has had difficulties in 2008 because the inflation is cost push. - High inflation also occurs with lower growth.

Will Lower Interest Rates Avoid Recession?

Around the world, Central Banks are cutting interest rates in the hope that they will avoid a serious recession. Lower interest interest can help boost economic growth because:
It reduces the cost of borrowing and therefore encourages firms to invest and consumers to spend. However, saving rates are already very low. Consumers might not want to borrow, even though it is cheaper because they fear the future. Also banks may be unwilling and unable to lend mortgages because of the credit crunch. In other words, lower interest rates may not encourage more borrowing in the current climate.

Lower interest rates reduce the cost of mortgage repayments. This increases the disposable income of consumers and reduces the number of mortgage defaults. Therefore, this helps increase consumer spending and will help halt the slide in house prices. This should act as a boost to economic growth.

Lower interest rates reduce the incentive to save, and therefore spending may increase.

Lower interest rates also cause a depreciation in the exchange rate. There is less demand for a currency like sterling. Therefore, it helps boost exports and economic growth. However, with many countries cutting interest rates, this may not help much. Also, the global slowdown means that export demand is likely to fall.

Lower interest rates will provide some help to economies in recession. However, it is not a panacea. There are many other significant problems (such as credit crunch) which a cut in interest rates doesn't solve.

Will A Stock Market Crash Cause A Depression?

Recently, I looked at the causes of the Great Depression. Many assume the Wall Street Crash of 1929 and the Great Depression are synonymous. The Stock Market Crash of October 1929 undoubtedly played a significant part in precipitating the crisis and 79 years later people may rightly worry over the similarities between the situation then and now. However, a stock market crash doesn't necessarily have to lead to a full scale depression.

The real cause of the Great Depression was the banking failure that spread through the country during 1930. It was the collapse in confidence and decline in the money supply that led to the unprecedented decline in National Output. Today, the falling stock market is symptomatic of the malaise affecting financial markets and the wider economy. The stock market is falling because:

• The global downturn is now expected to be much worse than previously anticipated. A global recession will reduce the profitability of firms and hence dividends.
• Uncertainty over the Banking system. Despite a variety of bank rescue packages, there is still uncertainty about whether they will work. Any sign of more banks going bankrupt could precipitate a financial meltdown which would have catastrophic results. Although this is unlikely the mere possibility is causing people to switch funds into something safe.