PRESIDENT CARTER LECTURES THE FOREIGN EXCHANGE MARKETS

Mini-Case
1. How were financial markets likely to respond to President Carter's lecture? Explain.
ANSWER.
Skeptically. Markets are in fact marvelously efficient systems for collecting
and assessing information, and as such their judgments are not stupid but smart.
Time and again markets have demonstrated their ability to outwit Wall Street
hotshots, central bankers, economic advisers, and especially politicians.
2. At the time President Carter made his remarks, the inflation rate was running at about
10% annually and accelerating as the Federal Reserve continued to pump up the money
supply to finance the growing government budget deficit. Meanwhile, the interest rate on
long-term Treasury bonds had risen to about 8.5%. Was President Carter correct in his
assessment of the positive effects on the dollar of the higher interest rates? Explain. Note
that during 1977, the movement of private capital had switched to an outflow of $6.6
billion in the second half of the year, from an inflow of $2.9 billion in the first half.
ANSWER.
Interest rates were high because the market was expecting continued high
inflation owing to rapid growth of the U.S. money supply. As such, the
international Fisher effect tells us that the high U.S. interest rate was forecasting
depreciation of the dollar, not appreciation. If these high nominal rates actually
indicated high real rates, then money should have been flowing into the United
States, not out of it as was happening.
3. Comment on the consequences of a reduction in U.S. oil imports for the value of the U.S.
dollar. Next, consider that President Carter's energy policy involved heavily taxing U.S.
oil production, imposing price controls on domestically produced crude oil and gasoline,
and providing rebates to users of heating oil. How was this energy policy likely to affect
the value of the dollar?

ANSWER.
Oil imports were slowing down because U.S. economic growth was slowing
down. According to the asset-market model of exchange rate determination, this
made the U.S. a less attractive place to invest money in and put downward pressure
on the dollar. Cutting oil imports by slowing down economic growth is equivalent
to burning down the barn to get rid of the mice. If President Carter really wanted to
pursue sensible economic policies that would lead to fewer oil imports, he should
have offered up an energy program that increased incentives for domestic oil
production and for domestic energy conservation. Instead, his policies taxed
domestic production and subsidized domestic consumption. The resulting
distortion in investment and consumption patterns reduced U.S. economic
efficiency and caused the dollar to decline.
4. What were the likely consequences of the slowdown in U.S. economic growth for the
value of the dollar? the U.S. trade balance?
ANSWER.
Chapter 2 showed that healthy economies have strong currencies and sick
economies have weak currencies. Rapidly growing economies use more of the
world's resources, and this shows up in the trade figures as a larger trade deficit.
But this does not normally lead to a depreciation of the growing economy's
currency. Normally what happens is that a growing economy attracts investment
and foreign capital, which offsets the larger trade deficit. The result is a stronger
currency, not a weaker one. This theory was borne out in the early 1980s when the
rapid growth of the U.S. economy resulted in a large trade deficit and a soaring
dollar.
5. If President Carter had listened to the financial markets, instead of trying to lecture them,
what might he have heard? That is, what were the markets trying to tell him about his
policies?
ANSWER.
The flight from the dollar was a massive vote by the financial markets of no
confidence in the Carter Administration's economic policies. The markets were telling

him that they thought his policies were inflationary and anti-growth. Dollar-denominated
assets were marked down because the markets saw that the dollar's value was eroding
both at home and in relation to other currencies abroad. At the same time that the
inflation rate was declining in Germany, Japan, and even the U.K., it was accelerating in
the United States. Yet the Federal Reserve was continuing to pump reserves into the
banking system, leading to expectations of higher inflation down the road. Simply put,
the dollar was not declining because the U.S. was importing too much oil or growing too
fast; the dollar was declining because too many dollars were being printed and because
the world had lost confidence in the Carter Administration's economic policies. The
markets were clearly telling him it was time for a change in his policies. By October
1979, the message had gotten loud enough that President Carter's newly appointed
chairman of the Federal Reserve Board, Paul Volcker, instituted a new monetary policy
that dramatically slowed down the growth of the U.S. money supply. But it was not until
Ronald Reagan became president that the United States instituted pro-growth economic
policies--in the form of big tax cuts and a reduction in the anti-business policies and
rhetoric so common under Jimmy Carter.