16.3 Fiscal Policy under Flexible Exchange Rates

The risk premium could be positive if the foreign country is thought to be riskier than the United States, as is the case with Canada. It could be negative if the foreign country is thought to be less risky than the United States, as may be the case with Switzerland. Because the risk premium is never known, and because monetary policy can cause a country's real interest rate in the short run to depart slightly from this formula, as explained in curiosity 18.1, this formula is best viewed as a rule of thumb useful for predicting long-run behavior and for analyzing differences between countries' nominal interest rates.
Media Illustrations
Example 1
At the same time that Secretary Blumenthal was testifying to Congress, the Treasury borrowed $1.6 billion in Germany in the form of securities denominated in marks. It offered to pay an interest rate of roughly 6 percent per year on mark-denominated three-and four-year securities. On comparable securities denominated in dollars, the Treasury is currently paying about 9 percent or 3 percentage points per year more.
Why is the rate of interest offered on mark-denominated securities less than that offered on dollar-denominated securities?
The value of the U.S. dollar, relative to the German mark, must be expected to decline during the next three or four years.
Assuming that mark- and dollar-denominated securities are risk-equivalent, what would you guess is the difference between U.S. and German inflation?
If these securities are risk equivalent, the difference in nominal interest rates should be due mainly to expected inflation differences, so a good guess would be 3 percent.
What does the U.S. Treasury believe about the future value of the U.S. dollar in terms of marks? What do German investors buying these securities believe?
If the value of the U.S. dollar fell by 3 percent per year over the life of these bonds, the cost to the U.S. Treasury would be the 6 percent interest plus the 3 percent fall in the exchange rate, for a total cost of 9 percent, equivalent to the cost of selling bonds denominated in dollars. Consequently, the U.S. Treasury must believe that over the life of these bonds the value of the U.S. dollar will fall by less than 3 percent per year. The German investors could have bought bonds denominated in dollars and earned 9 percent less the exchange loss, but instead opted for the guaranteed 6 percent. Consequently, they must believe that the U.S. dollar will fall by more than 3 percent per year over the life of these bonds.
Example 2
The Fed has made occasional attempts to lower interest rates and accept some lowering of the dollar as a trade-off. Sometimes it works, and sometimes, like last summer, we end up with the worst of all possible worlds higher interest rates and a lower dollar.

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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