Exchange rates refer to the price at which a currency is being bought or sold using another currency. It is the national currency’s value in relation to foreign currency. These being the case exchange rates operate in accordance with the normal demand and supply curves. This implies that in cases of excess supply, prices (rates) go down and the reverse happens when demand is higher than supply levels. This means that exchange rates are determined by matching transactions involving currencies between two countries. Fixed exchange rates are determined by authorities charged with the responsibility of ensuring macro economic stability. However, in free economies such as the US, floating exchange rates are prevalent. This means that they are determined by the play out of variables in the market. Some of the most important determinants of exchange rates include the balance of values of imports and exports also called balance of payments, interest rates and inflation. Balance of payment is determined by how balanced the values of imports and exports are for the respective countries. Inflation on the other hand affects exchange rates when related to the inflation rate in the foreign country. A high inflation rate has the effect of depreciating local currency mainly because it implies that the value of local currency drops at a higher rate than that of the foreign currency. This paper evaluates the actions of the Federal Reserve and their effect on the exchange rates through the interest rate levels for the last five years (Reis, 2009, par. 4).
As has been explained earlier, exchange rates are prices of currency which follow the normal demand and supply conditions. When interest rates are low, liquidity in the market improves implying that local currency in circulation is high. This happens due to the fact that firms are willing to borrow more as the cost of borrowing is low. The high liquidity prevalent in the market means that the availability of local currency in relation to foreign currency is high. Following the laws of demand and supply, the value of the local currency is bound to drop resulting in a deterioration of the exchange rate.
The Federal Reserve is charged with the responsibility of ensuring macroeconomic stability in the US economy. This is done through manipulating money supply mainly through interest rates and public expenditures. The past five years have been dramatic for the Federal Reserve. The institution has been faced with unprecedented pressures. In the period prior to the economic crisis which sparked off late in the year 2007, the federal maintained the monetary policies at a relatively tight level compared to the later years. The bank rates in this period averaged at around 2%. Since the economy was on a high, the fiscal policies employed by the government were less in scale compared to the actions of the government after the confirmation of the economic crisis.
In the period between the year 2004 and 2007 monetary policy was tight due to the reasons stipulated above. This ensured that the interest rates were maintained at a level commensurate with the amount of economic activity happening at the time. Throughout this period, the US dollar had minimal depreciation against other world major currencies (Wayne, 2010, par.3-9).
The period after the confirmation of the onset of the economic crisis led to a rethinking of the federal reserves policies. The economic slump resulted in an acute slow down in the economic activities which started in the housing markets. The most affected sector was the financial market which experienced an almost perfect freeze in the flow of credit within the system.
According to the Federal Reserve chairman Ben Bernanke, the institution dealt with the crisis in three main strategies. The first strategy focused on minimizing the effects of the crisis on the flow of credit as well as the entire economy. The strategy was pursued by the Federal Open Market Committee (FOMC). This saw an aggressive campaign to ease the monetary policy to unprecedented levels. The federal funds rate which determines the cost at which the financial institutions borrowed from the Federal Reserve was drastically cut. The first cut was whooping 50% basis points but by the end of the year 2007, total reductions had reached the 100% mark. This literally means that the Federal Reserve has been lending money to banks almost freely (Bernanke, 2008, par. 4).
The second strategy involved offering banks as well as other financial institutions credit by improving terms of borrowing. The intention here was to boost the level of capital availability in the economy in a bid to jump start the economy. This strategy was conducted together with the third one and with the main aim. The third strategy focused mainly on the failed financial institutions which were presenting real challenges on the flow of credit and hence the recovery. Here, the fed together with the Treasury moved to acquire some major financial institutions while injecting large sums of money in others to get them on their feet. JP Morgan, Bear Steams and insures such as American International Group were some of the beneficiaries. These strategies were complemented by measures aimed at strengthening financial infrastructure mainly by improving the efficiency of the entire financial system (Frederic & Mishkin, 2007, par. 7).
As has been discussed, the strategies outlined above all attribute to increasing the amount of money supply in circulation within the economy. According to economic theory the effect of the increase in currency circulation in the economy ultimately means a rise in supply. A high supply of local currency in the economy under the laws of demand and supply demands that prices (rates) have to fall. The results for the economy were in line with the propositions of economic theory (Jeff, 2006, par.10). The almost unprecedented expansionary monetary policies have led to a drastic depreciation of the exchange rate for the US dollar. The situation has been aggregated by the fact that the economic crisis significantly reduced the ability of American population to purchase imports due to reduction in incomes. Inability to purchase led to less outflow of currency occurred as a result of importation. This means that most of the currency remains within the country which means consistently high supplies (Economic Effects of Exchange rate changes, 2010, par. 9).
The depreciated dollar has caused outcry among different economic units adversely affected by the deterioration in the exchange rates. As the US economy pulls out of the recession, a dilemma is slowly emerging as the Federal Reserve has to devise a suitable strategy to reverse the exchange rates without destabilizing the economy. This arises from the fact that the low exchange rates has the effect of reducing the prices of domestic goods in the international markets a situation which needs to be encouraged at all costs as a way of accelerating the rate at which the economy pulls out of the recession (Muehring, 2010, p. 8). A drastic appreciation of the US dollar is bound to make exports expensive in the international markets and this is likely to slow down the recovery process.
Annotated Bibliography
Reis, R., (2009). Exit Strategies and the Federal Reserve. Columbia University. Web.
Exit Strategies and the Federal Reserve
The article Exit: Strategies and the Federal Reserve, was written by Ricardo Reis from Columbia University. It seeks to elaborate the actions of the Federal Reserve within the past two years in the face of the economic crisis which has ravaged economies all over the world but whose origin is in the US. It gives direct stipulations on the extent to which the Federal Reserve has managed to push the monetary and fiscal policies in the US in response to the economic crisis.
Bernanke, B. (2008). Federal Reserve policies in the financial crisis. Web.
Federal Reserve policies in the financial crisis
The article is a speech given by the chairman of the Board of Governors of the US Federal Reserve System at the Greater Austin Chamber of commerce in Texas on December year 2008. In the speech Mr. Bernanke explains the three components of the Federal Reserves strategy in dealing with the financial crisis. He does this taking to consideration the consequences on the economy. The first component regards the attempts to offset to the best possible extent the effect of the crisis on the flow of credit in the economy as well as other areas of the economy. In executing this task, the fed used the open market operations to manipulate and increase money supply in the short term.
Mishkin, F. S. (2007). The Federal Reserve’s Enhanced Communication Strategy and the Science of Monetary Policy. Web.
The Federal Reserve’s Enhanced Communication Strategy and the Science of Monetary Policy
This is a speech given by Governor Fredric S. Mishkin on invitation by the Undergraduate Economics Association in Massachusetts Institute of Technology. He emphasizes the fundamental role played by the elements of expectations in the process of decision making both at the household level and the firm level. Proper communication strategies ensure proper reactions by the different economic agents both within and without the economy.
Economic Effects of Exchange rate changes, (2010). Tutor2u. Web.
Economic Effects of Exchange rate changes
The article: Economic Effects of Exchange rate changes have been published by an economic resource website called tutor2u for general use by scholars. It expounds on the relationship between exchange rates and other economic variables such as inflation, GDP as well elements of international trade such as exports and imports. It explains the lags between the changes in exchange rates and the resultant changes in the variables listed above. It also explains how monetary policies are linked to the rise or fall of exchange rates from a purely theoretical point of view.
Jeff L. (2006). Monetary Policy Tactics and Strategy. Web.
Monetary Policy Tactics and Strategy
The article is also a speech given by Jeffrey Lacker the president of the Federal reserve bank of Richmond at Baltimore Conventional Center Baltimore. The speech focused on the monetary policy and sought to distinguish between strategies and tactics in the application of the policies. According to him tactics refer to the daily actions or in the case of the fed, the quarterly actions taken in a bid to affect a monetary policy. They are the reported changes in the feds rate of interest and other short term actions. Strategies on the other hand are the longer term orientations towards the application of the monetary policies.
Wayne N. (2010). The Federal Reserve – Its Origins, History & Current Strategy. Web.
The Federal Reserve – Its Origins, History & Current Strategy
The article The Federal Reserve – Its Origins, History & Current Strategy is written by Wayne Krautkramer. It seeks to educate the reader on the intricacies of the strategies applied by the federal reserves. It starts by giving a background analysis of the formation of the Federal Reserve and the rationale behind the move. It also looks at the functions of the Federal Reserve Bank.
Muehring, K. (2010). Federal Reserve Exit Strategy Urged. Institutional Investor. Web.
Federal Reserve Exit Strategy Urged.
The article: Federal Reserve Exit Strategy Urged was written by Kevin Muehring. It seeks to lobby for the development of an appropriate strategy for the Federal Reserve to employ in taking the American economy back to normal after employing extreme monetary policies. The article outlines the effects of the feds action on exchange rate and the destabilizations likely to occur in the case the fed abruptly reverses monetary policies without taking considerations to the effects on exchange rate as well as other variables.
Reference List
Bernanke, B. (2008). Federal Reserve policies in the financial crisis. Web.
Economic Effects of Exchange rate changes, (2010). Tutor2u. Web.
Jeff, L. (2006). Monetary Policy Tactics and Strategy. Web.
Mishkin, F. S. (2007). The Federal Reserve’s Enhanced Communication Strategy and the Science of Monetary Policy. Web.
Muehring, K. (2010). Federal Reserve Exit Strategy Urged. Institutional Investor. Web.
Reis, R. (2009). Exit Strategies and the Federal Reserve. Columbia University. Web.
Wayne N. (2010). The Federal Reserve – Its Origins, History & Current Strategy. Web.