The Weak Dollar and Inflation
Here is a report from ABC News about the Congressional Joint Economic committee hearing on November 8, 2007. Presidential candidate congressman Ron Paul questioned Federal Reserve Chairman Ben Bernanke about the operations of the Fed, in regard to expanding bank reserves.
“Paul vs. Bernanke on the Value of the Dollar”
by Z. Byron Wolf, ABC News
I wish Ron Paul were better focused. His ranting at Bernanke about “printing money” is based on his elementary reading of classical economic theory. Those great cassical economics writers mostly emphasized the cause of inflation as increases in the money supply. But the value of money, like the value of everything else, is determined by supply and demand. In today’s monetary system, explaining inflation requires understanding also the demand side. An increase in the supply of money today is less important than whatever impacts the demand for money, particularly in foreign exchange markets - when the demand drops and good alternatives like the Yen and Euro are available.
In the classical economic model, the demand for money is a constant force, or it changes very slowly. The supply of money, e.g. a printing press, gives all the action. Everybody understands the “bountiful harvest” model: a larger supply of apples reduces the price of each apple. Likewise, more dollars; cheaper dollars.
But even if the harvest is not up, the same thing would happen to the price of apples if people decided to stop buying them due to some fad or concern they might be bad for your health. When the international, outside-the-USA demand for dollars falls, the exchange rate of the dollar also falls. Dollar-prices of U.S. imports increase, and with oil among the greatest imports, the cost-pressure hits every sector of the U.S. economy. Domestic price level inflation is mostly due to rising import costs, not domestic factors. It is not due to a surge in the supply of domestic U.S. dollars.
Ron Paul should have asked chairman Bernanke whether he thinks the Federal Reserve can ultimately affect the demand for the U.S. dollar merely by manipulating bank reserves and the Federal Funds interest rate? In other words, he should have asked about Bernanke’s central operating tool - and whether it really works in today’s open economy, with a globalized demand for dollar-denominated assets (particularly U.S. currency). The Federal Reserve periodically studies how much U.S. currency leaves the country every year: the number is something like 80 percent of newly printed U.S. currency is exported to foreign banks.
So to understand the plunging foreign exchange value of the “weak” dollar, the real question is why all those really smart foreign investment managers, in Europe and Asia, are beginning to have doubts about the United States economy and the leadership of President Bush? They’re dumping dollars, and Bernanke can’t do anything about it. Is there a possibility here they are growing cautious due to the evidence of mistakes and an over extended foreign policy?
And what could Ron Paul’s proposal for a classical gold standard do about that? Not much.