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Macroeconomics: International Finance

  1. Apr 24, 2012 #1
    Suppose the U.S government decides to drastically reduce the required liquidity ratio for banks, causing the money supply to skyrocket and interest rates to plunge. How will this affect the value of the dollar in terms of other currencies, assuming that all other things remain constant (in both the US and around the world) ?

    My blunt guess is that money supply and strength of currency are inversely proportional, but I would also imagine that speculators can somehow restabilize the value of the currency even if the money supply is changed.

  2. jcsd
  3. May 3, 2012 #2
    I'm not sure how can interest rates for US dollar "plunge", when at least formally US dollar o/n LIBOR interest rate is round 0.147%. (Annual barely exceeds 1%)

    Second thing is the extend to which banks would hold anyway higher liquidity ratio than required by regulators. In my country (Poland) such thing happens so I would not consider that as guaranteed way to increase money supply. (sure, presumably in US bank would use that chance but it doesn't mean that it would mean skyrocketing money supply)

    On more thing with so low interest rates the limiting factor is the credibility of your counterpart. If you are about to lend someone money and the annual rate is 0,1% you might wonder whether this is worth the risk and it would be better to keep that in your central bank.

    Other constant? Should slightly decrease the value of the currency.
  4. May 3, 2012 #3
    Based on the previous posters comments: I’d worry more about money supply changes due to injections of base money from the federal reserve; then changes due to liquidity ratios. Keep in mind that capital ratios are more likely to constrain the banks then liquidity ratios. You are right that an expansion in the money supply will weaken the currency and it has in terms of such things as, food, commodities, and stocks.

    The inflation in the money supply has yet to have a large effect on the CPI because the money is not injected into the economy evenly. People who can borrow cheaper than inflation can essentially make free money by buying commodities and then selling them at inflated prices. It is these people who could be called the early beneficiaries of what some might call counterfeiting.

    For the people who are able to borrow cheaper than inflation there is still a high risk of the bubble bursting in commodities like Gold from contractionary forces such as increases in the interest rate shocks. Interest rate risk could be hedged against by shorting bonds.
  5. May 12, 2012 #4
    The supply of US dollars goes up, and assuming demand for US dollars stays the same, the price for US dollars will drop. The exchange rate will change accordingly.
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