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February 1, 1 980
Falling Dol lar?
Many financial observers have argued that
when (or if) the economy weakens this year,
real G N P will fall, and thereby lead to lower
money demand and interest rates. These
developments, they argue, will then put
downward pressure on the dollar in foreignexchange markets. But will a weakening
economy necessariIy lead to a weaker dollar?
For a number of reasons, the results should
be otherwise.
The crucial pointto remember is the nature of
the initial disturbance which is generally
expected to affect the 1 980 economy. The
expectation
is for a cyclical decline (or
deceleration) in the nation's aggregate
demand. This disturbance would then
generate all the other effects-on income,
money demand, and interest rates. On this
basis, we could well conclude that the
cyclical decline in demand will in fact
strengthen the dollar.
Exchangerates,and a weakeningeconomy
A year or two ago, many analysts argued that
the dollar was weak because the U.S.
economy was strong, with real GN P rising
faster in this country than abroad. The idea
was that the cyclical upturn was stimulating
imports and so weakening the trade deficit,
and also pushing up prices-in both cases
weakening the dollar. Yet some of these same
commentators are arguing now thatthe dollar
wi II weaken as the economy weakensignoring the now beneficial effects on trade
and prices, and instead concentrating on the
supposed effects of lower interest rates. The
two positions are clearly inconsistent.
With respect to the earlier (1978) situation,
empirical evidence supports the view that
upward cyclical movements in income had
generated a downward movement in dollar
exchange rates. Therefore, today, the reverse
would be expected: downward cyclical
movements should lead to an improvement
in prices and in the balance of payments, and
so to an improvement in the outlook for the
dollar.
The argument fQr a weaker dollar tends to
confuse (in economists' jargon) a movement
alonga money-demand
schedulewith an
enormous shiftin thatschedule.True enough,
in the latter case, when economic actors
suddenly decide to hold fewer dollars than
previously at any given level of prices,
interest rates, and exchange rates,the dollar
should weaken. But that is not
situation
that we are currently discussing. Rather, in
the present case, the initial disturbance is in
the goods markets, and falling income and
falling interest rates will then have offsetting
effects on the quantity of money demanded.
The initial disturbance should cause prices,
incomes, and interest rates to change to
maintain equilibrium in all markets, but
without an autonomous decline in money
demand, there need be no weakening in
dollar exchange rates.
Some might argue that the dollar should
weaken as foreign investors reduce their
demand for dollar assets,because of the
decline in U.S. interest rates associated with a
weakening economy. But in net terms,
demand for U.5. assetsneed not be any lower
than before, because U.S. investors are likely
to make up for the decline in foreign demand.
In other words, the market should be willing
to hold the same or a larger amount of assets
at lower interest rates because domestic
purchasers, when reducing their demand for
goods during an economic slowdown, are
likely to increase their demand for assets at
the same time. That is, foreign investors are
not getting out of dollars because of a decline
in confidence for dollar assets,but rather
because aggressive buying by U.S. investors
is pushing down interest rates and bidding
them out of the market. Again, in that event,
there need be no decline in the value of the
dollar.
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Opinions
in this nevlisletter do not
necessarilv retlect the vi(::)ws of the management
of thE' Federal Reserve Bank of San Francisco,
nor of the Bcurd (if
of the federal
Rpse rvp ")Is
if'nl,
Endogenous
variables
October 6 has focused directly on
bank-reserve growth rather than on the
Federal-funds rate. Market participants might
decide that if the monetary authorities try to
hold interest rates up on the downside of the
business cycle, they will also likely try to hold
interest rates down on the upside of the cycle.
Such a perception would increase long-run
inflation expectations, and thus reduce
long-run confidence in the dollar.
The argument linking falling interest and
exchange rates also seems specious because
it posits a close relationship between two
variables, interest rates and exchange rates,
both of which are in fact endogenous. The
argument suggests that interest rates
determine exchange rates. Yet in reality, both
variables respond to disturbances or shocks
to underlying economic parameters. Some
types of shocks wi II cause them to move in
opposite directions. Thus, knowing only how
interest rates are changing need not tell us
anything about how exchange rates are
changing.
To understand this argument, recall that we
have emphasized that no automomous
decline in money demand is likely to occur
during the cyclical decline this year.
However, eve I} if one were to occur, the issue
wou Id then sh'ift to whether the Fed shou Id
drop its money supply targets and hold
interest rates up in response to such a
disturbance. Now for years, economists have
argued over whether the Fed shou Id target
monetary aggregates or interest rates in
response to shocks to the economy. The
argument for concentrating on the
aggregates, which is implicit in the Fed's
October 6 policy shift, centers around the
poi nt that the Fed wou Id be forced to make
constant changes in the money supply if it
attempted to iron out every shock to interest
rates. Such a process would destabilize the
money supply, and in extreme cases could
lead to explosive inflationary or deflationary
episodes. By endeavoring to control the
money supply instead, the Fed permits the
market to determine interest rates and
,
allocate credit. Short-run interest fluctuations
may be more erratic, but over the long-run,
interest rates (and exchange rates) wi II be'
more stable, simply because periods of
severe inflation or recession will be avoided
through better control of the money supply.
For example, as argued above, a shock to
aggregate goods demand will cause interest
and exchange rates to move in opposite
directions. Similarly, a decline in inflation
expectations in the U.S. would lower U.S.
interest rates and strengthen dollar exchange
rates: again moving them in opposite
directions. However, changes in money
supply or money demand would-in
the
short-run, at least-move interest and
exchange rates in the same direction. The
analysts linking falling exchange rates to
cyclically declining interest rates have
apparently confused the resu Its from
money-demand or money supply shifts with
the phenomena of aggregate demand sh ifts
such as we have already discussed.
Monetary-control perspective
Even if there were some theoretical basis for
linking falling interest rates and falling
exchange rates, there is no practical reason
for deliberately keeping interest rates high (by
slowing money growth), as a means of
calming exchange markets and strengthening
the dollar. Indeed, such a step could be
counterproductive, by leading market
participants to question the direction of
Federal Reserve policy, which since last
Thus, the Fed may improve short-run stability
if it were to hold interest rates steady in the
face of every alleged shift in money demand,
2
doubting that falling interest rates at home
will weaken the position of the dollar abroad,
and/or that policy should tighten further to
keep rates high. This popular argument can
be criticized on theoretical grounds for
involving several basic fallacies, which
misinterpret the nature of money demand
and mistakenly link the movements of
interest rates and exchange rates. Finally, in
practical terms, it appears questionable
because it wou Id suggest that the Fed shou Id
reverse a pol icy decision made on the basis of
long and thoughtful study.
but it would do so at the almost certain
expense of greater long-run instability in the
economy. The argument is not that further
tightening now would be bad in and of itself,
but that it wou Id engender expectations of
continued erratic (and perhaps explosive)
money growth in the future. Therefore,
expectations of future money growth and
inflation could undo any beneficial effects
obtained from further tightening of policy in
the present situation.
In sum, our analysis suggeststhat there are
both theoretical and practical reasons for
MichaelBazdarich
AlternateStrategies
TowardInflation
The Fall 1 979 issue of the Economic Review contains four articles discussing various aspectsof
inflation. The articles are titled:
* The Phenomenon of Inflation, and the Prospects for Anti-Inflation Policy
* Conducting Effective Monetary Policy: The Role of Operating Instruments
* Optimal Control and Money Targets: Should the Fed Look at "Everything"?
* Exchange-Rate Policies and Inflation: Theory and Evidence
For free copies of this and other Federal Reserve publications, write or phone the Public
Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco,
California 941 20. Phone (415) 544-21 84.
3
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BANKINGDATA- TWElFrH FEDERALRESERVE
DISTRICT
(Dollar amounts in millions)
SelectedAssetsandliabilities
large CommercialBanks
Loans(gross,adjusted)and investments*
Loans(gross,adjusted)- total#
Commercial and industrial
Realestate
Loansto individuals
Securitiesloans
U.s. Treasurysecurities*
Other securities*
Demand deposits- total#
Demand deposits- adjusted
Savingsdeposits- total
Time deposits- total#
Individuals, part. & corp.
(LargenegotiableCD's)
WeeklyAverages
of Daily Figures
M8nber BankReserve
Position
ExcessReserves(+ )/Deficiency (-)
Borrowings
Net free reserves(+ )/Net borrowed(-)
Amount
Outstanding
1/16/80
137,601
114,914
32,929
43,859
24,536
1,559
7,147
15,540
46,207
33,596
28,564
58,977
50,127
21,478
Weekended
1/16/80
Change
from
1/9/80
365
351
61
+ 230
75
85
+
12
+
2
+
634
- 509
- 233
- 121
149
445
Changefrom
yearago@
Dollar
Percent
+
+
-
i
I
+ 17,210
+ 16,620
+ 4,196
+ 8,588
+ 4,479
242
527
+ 1,117
+ 3,704
+ 2,205
1,686
+ 8,020
+ 8,811
+ 2,111
Weekended
1/9/80
+
+
+
+
+
+
+
+
+
+
+
14.30
16.90
14.60
24.30
22.30
13.40
6.90
7.70
8.70
7.00
5.60
15.70
21.30
10.90
Comparable
year-agoperiod
68
208
139
68
30
38
14
61
47
+1,807
+1,795
+1,050
-
+
-
FederalFunds- SevenLargeBanks
Net interbank transactions
[Purchases(+ )/Sales(-)]
Net, U.s. Securitiesdealertransactions
[Loans(+ )/Borrowings(-)]
68
72
+
445
* Excludestrading account securities.
# Includesitems not shown separately.
@ Historicaldataarenot strictlycomparable
dueto changes
in the reportingpanel;however,adjustments
havebeenappliedto 1978datato removeasmuchaspossibletheeffectsof thechanges
in coverage.
In
addition,for someitems,historicaldataarenot availabledueto definitionalchanges.
Editorialcommentsmaybe addressed
to theeditor(WilliamBurke)or to theauthor•... Freecopiesof
thisandotherFederalReserve
publications
canbe obtainedby callingor writingthe PublicInformation
Section,FederalReserveBankof SanFrancisco,P.O.80x 7702, San Francisco94120.Phone(415)
544-2184.
@FedFRASER