Financial Markets and Institutions (2-downloads)

Effective Exchange Rate

15

20

10

5

0

1974

1978

1982

1986

1994

1998

2002

1990

Interest

Rate (%)

175

150

125

100

Effective

Exchange Rate 

(Index: March

1973 = 100)

Real

Interest

Rate

Nominal

Interest Rate 

2006

2010

F I G U R E   1 5 . 8

Value of the Dollar and Interest Rates, 1973–2010

Sources: Federal Reserve: 

www.federalreserve.gov/releases/h10/summary/indexn_m.txt

; real interest rate

from Figure 3.1 in Chapter 3.

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364

Part 5 Financial Markets

16

12

8

4

0

–4

1955

1960

1970

1990

2000

Interest

Rate (%)

2005

2010

1980

1965

1975

1995

1985

Estimated Real Rate

Nominal Rate

F I G U R E   1 5 . 9

Real and Nominal Interest Rates (Three-Month Treasury Bill), 1953–2010

C A S E

The Subprime Crisis and the Dollar

With the start of the subprime financial crisis in August 2007, the dollar began an accel-

erated decline in value, falling by 9% against the euro until mid-July of 2008, and

6% against a wider basket of currencies. After hitting an all-time low against the euro

on July 11, the dollar suddenly shot upward, by over 20% against the euro by the

end of October and 15% against a wider basket of currencies. What is the relation-

ship between the subprime crisis and these large swings in the value of the dollar?

During 2007, the negative effects of the subprime crisis on economic activity were

mostly confined to the United States. The Federal Reserve acted aggressively to lower

interest rates to counter the contractionary effects, decreasing the federal funds rate

target by 325 basis points from September of 2007 to April of 2008. In contrast, other

central banks like the ECB did not see the need to lower interest rates, particularly

because high energy prices had led to a surge in inflation. The relative expected

return on dollar assets thus declined, shifting the demand curve for dollar assets to

the left, as in Figure 15.5, leading to a decline in the equilibrium exchange rate. Our

analysis of the foreign exchange market thus explains why the early phase of the sub-

prime crisis led to a decline in the value of the dollar.

We now turn to the rise in the value of the dollar. Starting in the summer of 2008,

the effects of the subprime crisis on economic activity began to spread more widely

throughout the world. Foreign central banks started to cut interest rates, with the

expectation that further rate cuts would follow, as indeed did occur. The expected

decline in foreign interest rates then increased the relative expected return of dollar

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Chapter 15 The Foreign Exchange Market

365

assets, leading to a rightward shift in the demand curve, and a rise in the value of the

dollar, as shown in Figure 15.4. Another factor driving the dollar upwards was the “flight

to quality” when the subprime financial crisis reached a particularly virulent stage in

September and October. Both Americans and foreigners now wanted to put their money

in the safest assets possible: U.S. Treasury securities. The resulting increase in the

demand for dollar assets provided an additional reason for the demand curve for dol-

lar assets to shift out to the right, thereby helping to produce a sharp appreciation of

the dollar.

C A S E