Download Week13-2

Disinflation, Crisis, and Global
Imbalances, 1980-2008
Firas Mustafa
1981-1983
• Federal Reserve Chairman Volcker makes a
change in U.S. monetary policy
– Aimed at fighting domestic inflation and stemming
the dollars fall
– Resulted in monetary slowdown which increased
the confidence the ForEx market had in the Fed’s
ability to lower inflation
1981-1983 cont.
• Ronald Reagan was elected president in
November of 1980
– He ran on a campaign of lower taxes and anti-inflation
• The combination of Reagan’s election and the
new monetary policy held great short-term
effects on the dollar
– The value of the dollar greatly appreciated
– U.S. interest rates nearly doubled from 1978 to 1981
Foreign Effects
• The appreciation of the U.S. Dollar had very
negative effects on the rest of the world
– Importing U.S. goods grew more expensive
– Workers began to demand higher wages
• The higher inflation world wide
– The inflation that was negated in the U.S. was
basically exported to other countries
Foreign Response
• Central Banks
– To slow down the inflation in their countries,
Central Banks had to force the dollar to depreciate
– The banks achieved this through selling of dollar
reserves and buying back their own currency
• Doing this caused a monetary contraction for each
country
– Since many countries all responded in the same
way at the same time, a world wide recession had
occurred
Foreign Response cont.
• Second Oil Shock
– The recession became worse when the second oil
shock occurred at the same time as the world’s
economy was contracting
– This was the worst recession since The Great
Depression of the 1930’s
– Unemployment was its highest in nearly 40 years
• The U.S. made a quick recovery to its pre-recession
unemployment rate.
• Unemployment in Japan and especially Europe remained
permanently high.
– Dramatic drop in the inflation rates of industrialized
countries
Recovery
• The Reagan administration's fiscal stimulus
– Reagan decided to cut taxes and increase defense
spending in 1981
– The short term effect was a sharp fiscal stimulus
to the economy
– The effect of the stimulus was really seen in 1982
when it increased output both at home and
abroad.
Recovery cont.
• The U.S. fiscal expansion was greatly
contributing to world wide recovery
– However, this was coming at the cost of our
budget deficit.
• The increase in budget deficit was not met with
offsetting increases in saving or decreases in
investment.
• Thus, the current account plummeted to a deficit of
3.6% of GNP.
• This increased worries about the future stability of the
world economy.
The Plaza Accord in 1985
• To respond to the overvalued dollar and the U.S.
current account deficit, the Plaza Accord took
place
– The meeting was held in the Plaza Hotel in New York
and was attended by the U.S., Britain, France,
Germany, and Japan.
– The Plaza Accord was an agreement between the
governments to depreciate the U.S. dollar in relation
to the Japanese Yen the German Deutsche Mark
through intervention in the currency markets.
The Plaza Accord in 1985 cont.
– The accord also set out to decrease the current account deficit
• This would be achieved through the depreciation of the dollar
• Once the dollar was depreciated, the cost of importing U.S. goods
would be cheaper. This would make American goods more
competitive in the market, and decrease the current account deficit.
• Results of the Accord
– The Plaza Accord was successful in depreciating the dollar and
somewhat decreasing the deficit.
– The current account deficit was successfully decreased in
Europe, but was not successful in decreasing our deficit with
Japan
• This was not successful in Japan due to the structure of the trading
system. The system set many restrictions on imports that prevented
the U.S. from competing the Japanese domestic market.
Good Times (for us)
• By 1992 the U.S. economy was doing great with low
inflation, a booming stock market, and low
unemployment rates.
• But Japanese economy was not fairing as well
– The booming real estate and stock prices in Japan were
creating an asset bubble.
– The Japanese Government decided to puncture the asset
bubble, but in the process they created a recession that
began in 1992.
• The Japanese banking system was in turmoil for over a decade.
• The Yen depreciated greatly, going from 80 yen per U.S. dollar to
145 yen per U.S. dollar.
• By 1998 the country faced shrinking GDP, declining prices, and its
highest unemployment rate in 40 years.
Not So Good Times
• By the late 1990’s the world seemed to be
heading towards a global depression
– Japan started a Domino effect in East Asian currencies
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Thailand
Malaysia
Indonesia
Korea
– Russia defaulted on internal and external debts
– To counteract the global recession the federal reserve
and 11 European countries lowered interest rates
September 11, 2001
• After a decade of growth and prosperity the
U.S. would again face a time of trial
– After the attacks the Fed cut interest rates and
President Bush cut taxes to pull the U.S. out of a
short recession
– The tax cuts again put the U.S. in a major current
account deficit of 6.5% of GDP
– The dollar began to depreciate against the Euro
Credit Markets
• In 2007 the credit markets of the industrial
world faced much instability.
– The roots of the crisis were in the home mortgage
market
– The low interest rates caused a rise in home prices
in the U.S.
– The mortgage industry began to give riskier loans
to people who would not otherwise qualify
Interest Rates
• The interest rates were low in the period of 2003 to 2005
• They abruptly rose in 2006 and 2007
– This rise made many people unable to pay their mortgage payments
• Now the lenders could not find anyone to make loans to them. So
the Fed dramatically cut interest rates to fight off a recession.
– The cut of the interest rate caused a large depreciation of the dollar
• The current account deficit should have caused the interest rates to
rise, but the interest rates actually fell
– This occurred because foreign countries had enough global savings to
cover our deficit. Since our deficit was offset by a large amount of
savings, this caused the interest rates to fall.