Monday, January 4, 2010

Federal Reserve and Value of the Dollar


source: wiki

Firstly welcome back after Christmas break.

Readers Question: According to this graph the value of the dollar fluctuated significantly prior to the establishment of the Fed and then steadily declined way past any previous low levels. According to this (An exposition of the principles of modern monetary science in their relation to the national economy and the banking system of the United States 76th Congress, 1st Session, Senate Document 23), a primary reason for this institution was to help alleviate the wild swings in the value of the US currency. But, why then has the value of the dollar only declined since the existence of the Federal Reserve System? Is this not evidence as Ron Paul suggests, that the Fed should be stripped of it’s power?

A stable exchange rate can be one function of a Central Bank. But, arguably, it is less important than other objectives such as:
  • Economic growth, aiming for full employment, increasing living standards, and ensuring all benefit from the proceeds of growth.

The Federal Reserve state their objectives include:

To manage the nation's money supply through monetary policy to achieve the sometimes-conflicting goals of:
• maximum employment
• stable prices, including prevention of either inflation or deflation
• moderate long-term interest rates
Objectives of Federal Reserve

Since 1913, the Pound Sterling has depreciated more than the dollar. But, a depreciating currency doesn't mean necessarily that living standards are falling.

At certain times, a falling exchange rate can be beneficial. Recovery from the Great Depression was quicker amongst countries who removed themselves from the Gold Standard.

If the Federal Reserve had responded to this crisis 2007-09 by trying to maintain a stable dollar, it would have been the worst possible mistake. What is the point of increasing interest rates to maintain a strong dollar, if it exacerbates the great recession and leads to higher unemployment?

Amongst some commentators there is a great fear of inflation. The idea is that the government is making people less wealthy by reducing the purchasing power of currency. But, this hasn't happened. Real interest rates have been mostly positive. Since 1913, living standards have improved in the US. By purchasing power parity, GDP per capita is the second highest in the world. Using the Economist index, US has the 13th highest standard of living.

The real problems (in my opinion) facing US are:
  • Lack of Financial regulation which created recent crisis.
  • Declining real wages in past two decades (according to Working Life US)
  • Increased gap between rich and poor.
  • Lack of universal welfare state.

The decline in the dollar is the least of America's problems. - a reflection of changing relative economy sizes.

I do admire Ron Paul for his belief's in civil rights / not invading other countries, not torturing e.t.c. But, as an economist he worries about the wrong things.

See also: Austrian economics for more on these issues

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