Econ help
I've been confused on the relationship between interest rates, inflation, value of the dollar, exports, all that stuff basically ass lemester. But I finally asked the right person (he wrote his senior thesis in macroeconomics), and he explained it logically. If you're interested, I'm posting it
Step 1:
Fed buys bonds -> Money supply increases -> Liquid money is now a
relatively more abundant asset -> in order for people to hold that extra
liquidity the opportunity cost of holding it must be lower -> interest
rate falls (interest rate is the return you lose when you hold cash so
it is the opportunity cost of holding cash)
Alternative logic: Fed buys bonds -> demand for bonds increases -> price
of bonds rises -> interest rate falls (because the return on a bond is
fixed in absolute terms, not relative terms, ie you get X$ a year, and
when the price of a bond is higher that X$ is a smaller percentage of
the bond value -> lower interest rate).
When Fed sells bonds the logic works in reverse
Step 2: When interest rate falls, it becomes cheaper to borrow money ->
businesses can borrow more -> investment increases
Step 3: When interest rate falls, assets denominated in US dollars
become less attractive, because it is possible to earn higher interest
on securities issued in other countries. Investors sell US securities
and buy foreign ones. In order to do that, investors need to sell
dollars and buy foreign currencies (b/c when you sell US treasury bond
you get USD, and in order to buy European bond, you need euros). As a
result demand for US dollars falls, and US dollar becomes cheaper
relative to other currencies (depreciation).
Step 4: When dollar is worth less, goods made in the US cost less in
foreign currencies (because you can now buy more dollars for your euro,
and thus can buy more US stuff). As a result US exports increase, and
imports fall (since foreign goods are noe more expensive).
Consequently, when Fed buys bonds, investment and exports increase,
while imports fall. In theory this should help reduce trade deficit, but
it will also be accompanied by outflow of capital from the US, since
investors will sell US securities and buy foreign ones. THis will push
capital account towards deficit (net foreign investment will fall).
Good luck on government tomorrow!
Step 1:
Fed buys bonds -> Money supply increases -> Liquid money is now a
relatively more abundant asset -> in order for people to hold that extra
liquidity the opportunity cost of holding it must be lower -> interest
rate falls (interest rate is the return you lose when you hold cash so
it is the opportunity cost of holding cash)
Alternative logic: Fed buys bonds -> demand for bonds increases -> price
of bonds rises -> interest rate falls (because the return on a bond is
fixed in absolute terms, not relative terms, ie you get X$ a year, and
when the price of a bond is higher that X$ is a smaller percentage of
the bond value -> lower interest rate).
When Fed sells bonds the logic works in reverse
Step 2: When interest rate falls, it becomes cheaper to borrow money ->
businesses can borrow more -> investment increases
Step 3: When interest rate falls, assets denominated in US dollars
become less attractive, because it is possible to earn higher interest
on securities issued in other countries. Investors sell US securities
and buy foreign ones. In order to do that, investors need to sell
dollars and buy foreign currencies (b/c when you sell US treasury bond
you get USD, and in order to buy European bond, you need euros). As a
result demand for US dollars falls, and US dollar becomes cheaper
relative to other currencies (depreciation).
Step 4: When dollar is worth less, goods made in the US cost less in
foreign currencies (because you can now buy more dollars for your euro,
and thus can buy more US stuff). As a result US exports increase, and
imports fall (since foreign goods are noe more expensive).
Consequently, when Fed buys bonds, investment and exports increase,
while imports fall. In theory this should help reduce trade deficit, but
it will also be accompanied by outflow of capital from the US, since
investors will sell US securities and buy foreign ones. THis will push
capital account towards deficit (net foreign investment will fall).
Good luck on government tomorrow!