Monday, February 4, 2008

Why Textbooks Can be Proved Wrong

If you study economics, you will know that a cut in interest rates should cause a devaluation in the exchange rate. The reason is that lower interest rates, make it less attractive to save in the country therefore there will be less hot money flows and lower demand for the currency. This will cause exchange rate to fall. However, in the real world, we often see that the theoretical outcome doesn't happen.

For example, the Fed have cut US interest rates by 1.25% in the space of a few weeks. This is the equivalent of five 25 basis point cuts. Yet, since that period the dollar has hardly lost any value at all.

Why has the textbook explanation not proved to be correct?

  • The reason is that markets usually are predicting what will happen in the future, rather than just responding to current events. For example:
  • The markets may have anticipated the rate cuts in advance. Therefore, people would have sold dollars in the past. Therefore, when interest rate cuts occur, they have already been built into the price of the dollar.
  • The Interest rate cut alters the future prospects of the US economy. The dollar's weakness was partly related to the prospects of a US recession. These rate cuts have diminished the potential for recession. Therefore, speculators are more optimistic about the future of the US economy and US dollar.
  • Markets Don't believe the rate changes will last. When the UK was in the ERM in 1992, the government increased interest rates to 15% to protect value of Pound Sterling. However, the markets felt this interest rate increase was completely unsustainable and so they didn't buy pounds. They correctly predicted the government would have to soon reduce interest rates to prevent the recession get.
To summarise

Ceteris paribus, lower interest rates would reduce the value of an exchange rate. however, in the real world there are many other factors that go together to determine the exchange rate.

Recent Readers Questions on Economics Blog
  1. Sub prime Crisis and global credit markets
  2. Benefits of reducing the value of a currency
  3. Does the size of a country affect the rate of Economic Growth

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