INTRODUCTION The American dollar is viewed as the most powerful currency in the world today.

Now on the rebound after a two-year low for the euro, rising interest rates in the United States have caused the exchange rate of the euro to appreciate from $1.1680 to $1.1706, and the yen to appreciate from 118.21 to 117.97 yen. Increasing interest rates will continue depreciating the dollar and appreciating other foreign currencies, affecting the entire international economy; however, as long as the United States interest rates increase faster than in the “eurozone”, the dollar will remain on top of the international market. The Federal Reserve Bank raised the interest rate again in early November to 4% to battle increasing inflation in the American market and is planning on continuing the trend, making borrowing money much more expensive. The European Central Bank, however, has chosen to keep forgo its increase in interest rates because of the weakness of the euro, and the Bank of England has also remained unchanged. Because the United States government has been importing more goods from other countries than exporting goods to other counties, the American economy is experiencing a major trade deficit of nearly $66 million. Some people argue that the increasing deficit is only due to “one-time events including Hurricane Katrina and a strike at Boeing.” Even if the deficit is due to these aspects, the fact still remains that all international currencies continue to appreciate due to the increasing interest rates in the United States, and a major problem has developed in the American economy.


THEORY REVIEW AND ANALYSIS The increasing interest rates have caused the supply of American dollars to greatly

exceed the demand. This has contributed to the major trade deficit in the United States.

This excess of supply continues to depreciate the value of the dollar, or the price of the currency goes down. Overall, the trade deficit of the United States continues to depreciate the American dollar. This is called the Primary Effect. This theory also claims that a trade surplus will eventually lead to the appreciation of a national currency. As a result, exchange rates between the countries will change. The appreciating country will have a higher exchange rate because there will be more demand for the currency and less supply; likewise, the depreciating country will have a lower exchange rate because there will not be as great of a demand for that nation’s currency, so there will be an excess supply. When a country’s (Country A) currency depreciates, this has a major impact on future imports and exports. Due to the Secondary Price Effect, a devaluation of currency will eventually lead to an increase in exports and a decrease in imports, simply because it will be easier for foreign countries (Country B) to buy from Country A rather than to sell to the Country A. Country A’s goods will now become cheaper, and Country B’s goods will become more expensive all because of an initial trade deficit. However, since Country A will begin to import less and export more because of shifting prices, it will begin to reestablish equilibrium, or export and import an equal amount, reducing the trade deficit. Elasticity will also play a role in determining Country A’s Secondary Price Effect. If the price elasticity of demand for imports is very low, that is, consumers are not sensitive to a change in price, the reestablishment of equilibrium will take much longer. This is due to the fact that if County A’s currency appreciated by 1%, the demand for imports will increase less than 1%, which means that the people of Country A are not as enthused to buy foreign products even though they are cheaper. On the reverse side, if the price elasticity of demand


for imports is high, the equilibrium could be reached more quickly than if the elasticity was low. In other words, consumers are very sensitive to a change in price, so if the currency appreciates by 1%, the demand for imports will increase by more than 1%, and people would be more willing to buy foreign products. Not only price elasticity of demand, but price elasticity of supply must also be taken into account when determining the “size” of County A’s Secondary Price Effect. In the case of exports, the elasticity of supply is relatively similar to the price of elasticity of demand for imports. If the price elasticity of supply for exports is very low and the currency appreciates by 1%, the effect will be a decrease of less than 1% in the demand for exports. That is, if Country A’s currency gains value, Country B will be only slightly less willing to buy the products from Country A because of an increase in their price. However, if the price elasticity of supply for exports is high and the currency appreciates by 1%, a decrease of more than 1% in the demand for exports will prevail. In other words, if Country A’s currency appreciated, Country B will be much less willing to buy Country A’s products because of their price increase. The theory of Secondary Income Effect deals with how the appreciation or depreciation of a national currency will affect the national income. The theory states that when there is an initial trade surplus and a national currency appreciates, the net result will be an overall decrease in the National GDP. Being cheaper to import and more expensive to export, the national income will go down because profits from exports will decrease. The Secondary Income Effect now takes over and theorizes that since the GDP has gone down,


consumers will have less money to spend. This, in turn, will decrease the imports and increase the initial trade surplus. Depreciation of a national currency due to a trade deficit is similar to the appreciation situation when dealing with the Secondary Income Effect and more closely coincides with the situation of the United States. A trade deficit has been talked about as importing more and exporting less to foreign countries. The Secondary Income Effect says that this will cause the GDP go to up because other countries will be more willing to buy goods from the United States if they are cheaper than buying them domestically. Increasing the money supply in the country will then cause the demand for imports to rise, increasing the trade deficit that was the problem in the first place. The theories of appreciation and depreciation of a national currency have turned out to be quite true when observing the United States economy. Business Report stated that the United States has achieved a record budget deficit for the country, about $66.1 billion. When analyzing the source of the debt, one can see that the problem lies in the trade. The United States imports a larger proportion of goods from foreigners than it exports to other countries. Actions such as these that are kept up for some time will undeniably increase the countries budget deficit, causing the currency to eventually depreciate. This depreciation is exactly what has happened in the country. The dollar has depreciated against the euro, the yen, and the French franc. With persistent rising interest rates, the value of the country’s currency will continue to plummet. Eventually the United States will have to begin to import less and export more because of the national deficit, and hopefully begin to reestablish equilibrium. To counterbalance the Secondary Price Effect in the United States,


the Secondary Income Effect says that imports will increase again because of the increasing GDP. The United States is somewhat caught in the middle of an unending battle for equilibrium.


CONCLUSION The United States has gotten stuck in a situation that will be very hard to pull itself

out of. A budget deficit of nearly $66 billion is incredibly irresponsible and not only burdens the government, but burdens the American people as well. The question is, Why do other countries still respect the United States? The country is unable to repay their loans to foreigners and unable to satisfy it’s people. The American dollar is practically worthless because the government has the policy that they can just print more money, causing inflation, and the worries will disintegrate. I believe that the Bush administration should stop looking for ways of lowering taxes because there is no way to begin to decrease the budget deficit if a source of income keeps getting slashed. I think the government should change the Fiscal policy and increase taxes and decrease government expenditures in order to begin decreasing the deficit. Although some people might be politically opposed to this increase of taxes, I believe most people would be more willing to pay if it meant helping the government get out to debt. A change in the Monetary Policy would also be very effective in the case of the massive inflation. Continuing to increase interest rates, Reserve Requirement Ratios, and selling of bonds would decrease the money supply in the economy, which would reduce the inflation and limit people’s ability to import. With all the money saved up in the government, large debts could be paid off to foreign countries, and the dollar would start to appreciate and become more respected again in the international economy.


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