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February 16, 2011 – Comments (7)

Two quick things that I can’t quite make right in my head, if anybody knows this stuff, please help me understand it better.

 

1)   An increase in US income, according to my teacher and textbook, leads to a depreciation of the dollar because the supply of dollars rises.  However, wouldn’t more people buy the dollar is America was doing good, pushing it up?  I remember when the whole “European contagion” thing was in the news last year, the Euro kept plummeting, which is the opposite of what this suggests.

2)   According to my teacher and textbooks, if a country has high interest rates, people will want to put their money in that country.  To me, that makes no sense because high interest rates generally signal either higher interest rates coming due to inflation, or an unstable economy.  On top of that, it will be harder for companies to do business in that country because the cost of capital is so much higher.  According to my teacher and textbook, if this high interest rate thing happened in foreign countries, it would make the US markets fall and foreign ones rise.  Using empirical evidence, high inflation abroad has crushed emerging market ETF’s and boosted the US stock market.

It appears my empirical evidence contradicts my teachings...please help

                                                                                                                         

7 Comments – Post Your Own

#1) On February 16, 2011 at 2:48 PM, chk999 (99.97) wrote:

It helps if you think of it in purchasing power, not in dollars or Euros or whatever. Think of it as Big Macs. 

Now, if income is generally rising in a country, what this means is that there is inflation going on. (As opposed to income rising in one sector because of increased business.) So if there is inflation, there are more currency units chasing the same number of Big Macs, so the price of a Big Mac has to go up. This means that the currency unit is losing purchasing power.

Now think about interest rates. If interest rates are below the inflation rate, then buying bonds in that currency is silly, you lose ability to buy Big Macs. If interest rates are above inflation, then buying bonds or other securities paying that interest makes sense because you will be able to buy more Big Macs later with the bond principal and the interest. So money will migrate to bonds in currencies paying the highest REAL interest rate. (You always gotta figure out from the nominal rate and the inflation rate, what the real rate is.)

Does this help? 

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#2) On February 16, 2011 at 3:13 PM, Valyooo (99.43) wrote:

Yes, thanks...however as for #2 it just said "interest rates"...it didn't specify if it was nominal or real...otherwise it would make perfect sense.

Also, for number one that makes sense in the long term, but is it the same in the short term?  For instance, why was the Euro plummeting when europe was doing bad  last year?

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#3) On February 16, 2011 at 4:17 PM, whereaminow (22.35) wrote:

Under fiat currency, high interest rates are generally a tightening of monetary policy due to inflation, which generally leads to a contraction since the initial expansion was due to easy money which caused the inflation.

In the past, high interest rates meant that consumers in that country had a higher time preference and were willing to save more. This was considered attractive to investors.

Perhaps the textbook writers are confusing the two situations.

David in Qatar

 

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#4) On February 16, 2011 at 4:29 PM, Valyooo (99.43) wrote:

If they were willing to save more, wouldn tthat put downward pressure on interest rates?  As more people look to take out loans, interest rates go up to keep up with demand (banks can get away with charging higher rates since people want loans so badly).  When people want to save real badly, they will accept lower rates since they want to save.  Interest rates would be raised to incentivize more people to save, because that would be at a time when nobody wanted to save so the banks would be forced to raise rates to draw in more money

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#5) On February 16, 2011 at 5:06 PM, whereaminow (22.35) wrote:

If they were willing to save more, wouldn tthat put downward pressure on interest rates? 

I'm sorry Valyoo, nice catch. I meant higher interest rates increased incentive to save, under traditional conditions.

The point was that this doesn't apply anymore.

Daivd in Qatar

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#6) On February 16, 2011 at 5:23 PM, Melaschasm (53.80) wrote:

1.  You may be misunderstanding your teacher textbook, because this is not true.  All else being equal, rising incomes do not increase the money supply.  However, the USA does have a policy of increasing the money supply over time (the FED targets 2% inflation).  For example during the 1980's and 1990's the USA had strong increases in income, yet those two decades were considered a 'strong dollar' period.

2.  All things being equal, higher interest rates attracts investors.  For example, if the FED increases interest rates, it will attract more investment, if nothing else has changed.  From a practical stand point, the FED usually changes interest rates because of percieved changes in the economy. 

If interest rates were set by free markets, they would reflect the expected risks plus a profit premium.  However, most governments, including the US manage their interest rates in the hope of achieving various policy goals.  This distorts the markets and causes unexpected results.

 

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#7) On February 16, 2011 at 10:14 PM, GreenCollegeGrad (79.36) wrote:

Val if u get a second please hop over to my blog. Let me know if your at all interested in the idea Im proposing.

 Thanks man

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