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.

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
1

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
2.6.2

units of currency is worth $10,000.

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

2.6.3

foreign currencies for the corporation.

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

2.6.4

conducts the transaction promptly and handles any paperwork properly.

Advice about current market conditions. Some banks may provide
assessments of foreign economies and relevant activities in the

2.6.5

international financial environment that relate to corporate customers.

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 banks bid (buy) quote for a foreign currency will be less than its ask
(sell) quote.
3.2 Comparison of Bid/Ask Spread among Currencies
2

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 currencys 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 currencys 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
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
3

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.

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
4

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
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.
5

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.

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 20082009 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.
6

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
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
12.3

future.
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

12.4

underwriting crew.
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

12.5

for sale, thus allowing a more active secondary market.

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.

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
14.3

long-term interest rates rise, the required rate of return by investors rises.
Exchange Rate Risk
Exchange rate risk represents the potential for the value of bonds to decline
(from the investors perspective) because the currency denominating the bond

14.4

depreciates against the home currency of the investor.

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 MNCs parent may use international money or
bond markets to obtain funds at a lower cost than they can be obtained locally.

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 Holts
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 Holts
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.
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 1Ben Holt's Plan
9

Calculation of baht-denominated revenue:

Price per pair of "Speedos"
Pairs of "Speedos"
= Baht-denominated revenue

4,594
180,000
826,920,000

Calculation of baht-denominated cost of goods sold:

Cost of goods sold per pair of "Speedos"
Pairs of "Speedos"
= Baht-denominated expenses

2,871
72,000
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)
Interest earned on baht over a one-year period (15%)
Baht to be converted in one year
Expected spot rate of baht in one year
= Expected dollar receipts in one year

620,208,000
93,031,200
713,239,200
0.0147
10,484,616

Plan 2Immediate Conversion

Calculation of baht-denominated revenue:
Price per pair of "Speedos"
Pairs of "Speedos"
= Baht-denominated revenue
Calculation of baht-denominated cost of goods sold:
Cost of goods sold per pair of "Speedos"
Pairs of "Speedos"
= Baht-denominated expenses

4,594
180,000
826,920,000
2,871
72,000
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)
Spot rate of baht now
= Dollar receipts now
Interest earned on pounds over a one-year period (8%)
= Dollar receipts in one year
Calculation of pound difference between the two plans:
Plan 1
Plan 2
Dollar difference

620,208,000
0.016
9,923,328
793,866
10,717,194
10,484,616
10,717,194
(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
10

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
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.

11

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)

IFE

II.

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).

PURCHASING POWER PARITY

1. THE THEORY OF PURCHASING POWER PARITY
States that spot exchange rates between currencies will change to the differential in
inflation rates between countries.

12

Purchasing Power Parity Conditions :

In order to exist PPP we assume:

II.

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

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
C.

III.

ensures that eventually it will.

Absolute Purchasing Power Parity

RELATIVE PURCHASING POWER PARITY

A.
states that the exchange rate of one currency against another will adjust to
1.

reflect changes in the price levels of the two countries.

In mathematical terms:
t
et ( 1+i h )
=
eo ( 1+i f )t
where et
e0
ih
if
t

2.

=
=
=
=
=

future spot rate

spot rate
home inflation expected
foreign inflation exp
time period

If purchasing power parity is expected to hold, then the best prediction for the
one period spot rate should be
t
( 1+ ih )
e t=e0
t
( 1+if )

3.

A more simplified but less precise relationship is

et e 0
=i hi f
e0
that is, the percentage change in rates should be approximately equal to the

4.

inflation rate differential

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 :
13

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?
t
( 1+ ih )
e t=e0
=
1+i t

e 1=0,50(1,0577)

III.

e t=0,50

( 1,10 )1
( 1,04 )1

e 1=$ 0,529

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:
A. the spot rate adjusts to the interest rate differential between two
countries.
B. IFE = PPP + FE
t
et ( 1+i h )
=
eo ( 1+i f )t
C. Fisher postulated
1. The nominal interest rate differential should reflect the
inflation rate differential.
D. Simplified IFE equation:
e e
r hr f = t o
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.

14

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?
t
( 1+ ih )
e t=e0
=
1+i t

e 2=108

V.

e 2=108

( 1,1236 )
( 1,2544 )

( 1,06 )2
( 1,12 )2

e 2= 96,74/ $

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)

C.

where rh = the home rate

rf = the foreign rate
F = the forward rate
S = the spot rate
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
( 1+ r h )

F
=
S ( 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.
15

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
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
16

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.
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
17

big tax cuts and a reduction in the anti-business policies and rhetoric so common under
Jimmy Carter.

18