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How were financial markets likely to

respond to President Carter's lecture?
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

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
longterm 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.

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

Oil imports were slowing down because U.S. economic growth
was slowing down. According to the assetmarket 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?
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

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?

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 antigrowth. Dollardenominated 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 progrowth economic policiesin the form of big tax cuts and a
reduction in the antibusiness policies and rhetoric so common under
Jimmy Carter.