How does QE2 lead to Depreciation of Currency- MacroEcon here?
Hey all, its been in the news that with the Fed planning on QE2, it will lead to a depreciation of dollar, hence the reason why emerging markets are imposing capital controls. Can anybody please share their insight on how does Qe2 lead to US dollar depreciation?
My understanding is that as the Fed buys government bonds from the public, it leads to a an increase in the supply of money in the economy. People spend more , and price level increases. Imported goods become more attractive the way since they are cheaper, so ppl supply more US dollars in the economy, which depreciates the dollar. does anyone agree with my analysis? I dont understand how does imposing capital control help the emerging markets, and what do they mean by capital controls?
Please help!! Thanks guys
Well yes and no.
Depreciation of the currency occurs when more money is in the money supply. But the thing here is that the money from the fed is being used to buy treasuries and MBS from banks, who aren't increasing lending in this country but are instead converting to foreign currency and buying assets abroad. What this means is that it probably increases the holdings of banks and foreign holders, but that doesn't translate into consumer level spending which the CPI is a measure of. Since this does not increasing consumer level money supply (or this affect is muted) the velocity of money (the rate money changes hands) is not necessarily going to increase due to the stimulus. Mostly what matters in terms of economic growth is how much the banks increase lending which will filter down to the consumer level, and I don't know how much that is happening right now, as BoA and others are still deleveraging. Finally, the dollar is appreciating right now because international bond worries have maintained the "haven" status of the dollar coupled with a bounce back in the equities market that people are hoping will stick. If the value of the dollar increases then goods become cheaper and the consumer purchasing power of foreign goods is increased, independent of how many greenbacks are in circulation.
So, in a word, "it's complicated". But I hope I've raised a few relevant issues.
monkeysama I think you're off point. Theoretically, it should be like this: - Fed buys treasuries which in turn lowers interest rates and increases money supply - Low interest rates in the US means less investment in the US risk free rate - Capital moves out of the US and into foreign assets because of the lower yield, which also means that the dollar needs to be sold to buy these foreign assets. Although this is what QE2 is supposed to do, for some reason there is a different effect that is actually increasing the price of the dollar. I believe it has something to do with commodities, but I'm not entirely sure.
Yes this makes what sense, but then what do developing countries have to lose is foreign capital is flowing into their countries, since they are imposing capital controls?
For a theoretical explanation of how QE affects the exchange rate, check out the Mundell-Fleming economic model.
Excess money supply + lack of yield in the US means money will be flowing overseas. Now this will have an impact on the exchange rates by depreciating the dollar and appreciating the foreign asset. Emerging economies depend on exports to stay healthy, but by having a stronger currency, the number of exports will decrease.
As with everything in econ, there's a ton of things that go into it (some of which posts above touched on), but at the core of the issue is:
Fed purchases bonds, causing money supply to increase. Supply of money rises which lowers lowering interest rates, and creates excess dollars, which leads to a depreciation of the dollar.
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