What is Quantitative Easing? How did this policy impact the value of the U.S. Dollar? Please list three impacts and cite the textbook in your response.

conditions in the foreign exchange market. If the bre. money supply ENCIA DE HUEVO VENTA growing more rapidly than U.S. output, dollars will be relatively more Plentiful than the currencies of countries where monetary grows Closer to output growth. As a result of this relative increase in the supply of dollars, the dollar will depreciate on the foreign exchange 75 market against the currencies of countries with slower monetary 70 68 80 growth. Government policy determines whether the rate of growth in country's money supply is greater than the rate of growth in output MIL government can increase the money supply simply by telling the count try's central bank to issue more money- Governments tend to do this to finance public expenditure (building roads, paying government omen shop at an outdoor market in La Paz, Bolivia Bold's workers, paying for defense, etc.). A government could finance public Motion nie is much lower today than I was in 1985 but must expenditure by raising taxes, but because nobody likes paying more e carefully monitored. taxes and because politicians do not like to be unpopular. they have a Source: @ Wash Friedman-Rufousby Bloomberg/Getty Images natural preference for expanding the money supply. Unfortunately there is no magic money tree. The result of excessive growth in money supply is typically price inflation. However, this has not stopped gov. erniments around the world from expanding the money supply. with predictable results. If international business is attempting to predict future movements in the value of a country's currency on the foreign exchange market, it should examine that country's policy toward monetary growth. If the government seems committed to controlling the rate of growth in money supply. the country's future inflation rate may be low (even if the current rate is high) and its currency should not depreciate too much on the foreign exchange market. If the gov. ernment seems to lack the political will to control the rate of growth in money supply, the future inflation rate may be high, which is likely to cause its currency to depreciate. Histori- cally, many Latin American governments have fallen into this latter category, including Ar. gentina, Bolivia, and Brazil. More recently, many of the newly democratic states of eastern Europe made the same mistake. In late 2010, when the U.S. Federal Reserve decided to pro- mote growth by expanding the U.S. money supply using a technique known as quantitative easing. critics charged that this too would lead to inflation and a decline in the value of the U.S. dollar on foreign exchange markets, but are they right? For a discussion of this, see the accompanying Country Focus. Empirical Tests of PPP Theory PPP theory predicts that exchange rates are deter. mined by relative prices and that changes in relative prices will result in a change in exchange rates. A country in which price inflation is running wild should expect to see its currency depre- ciate against that of countries with lower inflation rates. This is intuitively appealing, but is it true in practice? There are several good examples of the connection between a country's price inflation and exchange rate position (such as Bolivia). However, extensive empirical testing of PPP theory has yielded mixed results." While PPP theory seems to yield relatively accurate pre- dictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less. " In addition, the theory seems to best predict exchange rate changes for countries with high rates of inflation and underdeveloped cap ital markets. The theory is less useful for predicting short-term exchange rate movements be- tween the currencies of advanced industrialized nations that have relatively small differentials in inflation rates. The failure to find a strong link between relative inflation rates and exchange rate move ments has been referred to as the purchasing power parity puzzle. Several factors may explain the failure of PPP theory to predict exchange rates more accurately." PPP theory assumes away transportation costs and barriers to trade. In practice, these factors are significant. and they tend to create significant price differentials between countries. Transportation costs are certainly not trivial for many goods. Moreover, as we saw in Chapter 7, governments rou tinely intervene in international trade, creating tariff and nontariff barriers to cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize prices for the 282 Part Four The Global Monetary Systemcountry FOCUS Quantitative Easing, Inflation, and the The Fed actually feared the risk of deflation (a persistent fall in prices), value of the U.S. Dollar which is a very damaging phenomenon, When prices are falling, peo- in fall 2010, the U.S. Federal Reserve (the Fed) decided to expand the pile hold off their purchases because they know that goods will be cheaper tomorrow than they are today. This can result in a collapse in U.5. money supply by entering the open market and purchasing aggregate demand and high unemployment. The Fed felt that a little geno bilion in U.S. government bonds from bondholders, a technique known as quantitative easing. Where did the $600 billion come from? Inflation-say, 2 percent per year-might be a good thing. Second, U.S. The Fed simply created new bank reserves and used this cash to pay economic growth had been weak, unemployment was high, and there was excess productive capacity in the economy. Consequently, if the for the bands. It had, in effect, printed money. The Fed took this action in an attempt to stimulate the U.S. economy, which, in the aftermath of Injection of money into the economy did stimulate demand, this would not translate into price inflation because the first response of busi- The 2008-2009 global financial crisis, was struggling with low eco- nesses would be to expand output to utilize their excess capacity. nomic growth and high unemployment rates. The Fed had already tried Defenders of the Fed argued that the important point, which the critics to stimulate the economy by lowering short-term interest rates, but seemed to be missing, was that expanding the money supply leads to these were already close to zero, so it decided to lower medium- to only higher price inflation when unemployment is relatively low and longer-term rates, its tool for doing this was to pump $600 billion into there is not much excess capacity in the economy, a situation that did The economy, increasing the supply of money and lowering its price. not exist in fall 2010. As for the currency market, its reaction was the interest rate. The Fed pursued further rounds of quantitative easing muted. At the beginning of November 2010, just before the Fed an- in 2011 through to 2013. In 2014 with the U.S. economy getting stron- nounced its policy, a trade-weighted index of the value of the dollar ger and unemployment falling below 6 percent, the Fed progressively against a basket of other major currencies stood at 72. At the end of reduced its bond buying program. It ended the program in October January 2014, It stood at 78-a slight appreciation. In short, currency 2014. By that time, the Fed had effectively pumped more than $3.5 trillion traders did not seem to be selling off the dollar or reflecting worries Into the U.S. economy. Critics were quick to attack the Fed's moves, Many claimed that about high inflation rates. By March 2016, with the program over, there was no sign of a surge the policy of expanding the money supply would fuel inflation and in price inflation in the U.S. economy. Indeed, inflation rates remained lead to a decline in the value of the U.S. dollar on the foreign ex- near historic lows. Moreover, far from weakening, the U.S. dollar had change market. Some even called the policy a deliberate attempt by increased in value against most currencies, and the index value stood at the Fed to debase the value of the U.S. currency, thereby driving 92. The Fed, it would seem, had been right and the critics were wrong. down its value and promoting U.S. exports, which, if true, would be a form of mercantilism. Sources: P. Walksten and S. Reddy, "Fed's Bond Buying Plan Ignites Growing Criticism," However, these charges may be unfounded for two reasons. First, at The Wall Street Journal, November 15. 2010; 5. Chan, "Under Attack, the Fed Defends the time, the core U.S. Inflation rate was the lowest in 50 years. In fact. Policy of Buying Bonds." International Heroid Tribune, November 17, 2010: "What Of Meens for the World; Positive Sum Currency Wars." The Economist, February 14, 2013. same product in different countries, which is required for the law of one price to hold. Government intervention in cross-border trade, by violating the assumption of efficient mar- bets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory. PPP theory may not hold if many national markets are dominated by a handful of multina- tional enterprises that have sufficient market power to be able to exercise some influence over prices, control distribulis s chumels, and differentiate their product offerings between nations." In fact, this situation seems to prevail in a number of industries. In such cases, dominant enter- prises may be able to exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions. This is referred to as price discrimination. For price discrimination to work, arbitrage must be limited. According to this argument, enterprises with some market power may be able to control distribution channels and therefore limit the un- authorized resale (arbitrage) of products purchased in another national market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical products among nations along some line, such as design or packaging. For example, even though the version of Microsoft Office sold in China may be less expen- sive than the version sold in the United States, the use of arbitrage to equalize prices may be limited because few Americans would want a version that was based on Chinese characters. The design differentiation between Microsoft Office for China and for the United States means Chapter Ten The Foreign Exchange Market 283