Disinflation, Crisis, and Global Imbalances, 1980-2008

1. Disinflation, Crisis, and Global Imbalances, 1980-2008 Firas Mustafa

2. 1981-1983 • Federal Reserve Chairman Volcker makes a change in U.S. monetary policy • Aimed at fighting domestic inflation and stemming the dollars fall • Resulted in monetary slowdown which increased the confidence the ForEx market had in the Fed’s ability to lower inflation

3. 1981-1983 cont. • Ronald Reagan was elected president in November of 1980 • He ran on a campaign of lower taxes and anti-inflation • The combination of Reagan’s election and the new monetary policy held great short-term effects on the dollar • The value of the dollar greatly appreciated • U.S. interest rates nearly doubled from 1978 to 1981

4. Foreign Effects • The appreciation of the U.S. Dollar had very negative effects on the rest of the world • Importing U.S. goods grew more expensive • Workers began to demand higher wages • The higher inflation world wide • The inflation that was negated in the U.S. was basically exported to other countries

5. Foreign Response • Central Banks • To slow down the inflation in their countries, Central Banks had to force the dollar to depreciate • The banks achieved this through selling of dollar reserves and buying back their own currency • Doing this caused a monetary contraction for each country • Since many countries all responded in the same way at the same time, a world wide recession had occurred

6. Foreign Response cont. • Second Oil Shock • The recession became worse when the second oil shock occurred at the same time as the world’s economy was contracting • This was the worst recession since The Great Depression of the 1930’s • Unemployment was its highest in nearly 40 years • The U.S. made a quick recovery to its pre-recession unemployment rate. • Unemployment in Japan and especially Europe remained permanently high. • Dramatic drop in the inflation rates of industrialized countries

7. Recovery • The Reagan administration's fiscal stimulus • Reagan decided to cut taxes and increase defense spending in 1981 • The short term effect was a sharp fiscal stimulus to the economy • The effect of the stimulus was really seen in 1982 when it increased output both at home and abroad.

8. Recovery cont. • The U.S. fiscal expansion was greatly contributing to world wide recovery • However, this was coming at the cost of our budget deficit. • The increase in budget deficit was not met with offsetting increases in saving or decreases in investment. • Thus, the current account plummeted to a deficit of 3.6% of GNP. • This increased worries about the future stability of the world economy.

9. The Plaza Accord in 1985 • To respond to the overvalued dollar and the U.S. current account deficit, the Plaza Accord took place • The meeting was held in the Plaza Hotel in New York and was attended by the U.S., Britain, France, Germany, and Japan. • The Plaza Accord was an agreement between the governments to depreciate the U.S. dollar in relation to the Japanese Yen the German Deutsche Mark through intervention in the currency markets.

10. The Plaza Accord in 1985 cont. • The accord also set out to decrease the current account deficit • This would be achieved through the depreciation of the dollar • Once the dollar was depreciated, the cost of importing U.S. goods would be cheaper. This would make American goods more competitive in the market, and decrease the current account deficit. • Results of the Accord • The Plaza Accord was successful in depreciating the dollar and somewhat decreasing the deficit. • The current account deficit was successfully decreased in Europe, but was not successful in decreasing our deficit with Japan • This was not successful in Japan due to the structure of the trading system. The system set many restrictions on imports that prevented the U.S. from competing the Japanese domestic market.

13. Good Times (for us) • By 1992 the U.S. economy was doing great with low inflation, a booming stock market, and low unemployment rates. • But Japanese economy was not fairing as well • The booming real estate and stock prices in Japan were creating an asset bubble. • The Japanese Government decided to puncture the asset bubble, but in the process they created a recession that began in 1992. • The Japanese banking system was in turmoil for over a decade. • The Yen depreciated greatly, going from 80 yen per U.S. dollar to 145 yen per U.S. dollar. • By 1998 the country faced shrinking GDP, declining prices, and its highest unemployment rate in 40 years.

14. Not So Good Times • By the late 1990’s the world seemed to be heading towards a global depression • Japan started a Domino effect in East Asian currencies • Thailand • Malaysia • Indonesia • Korea • Russia defaulted on internal and external debts • To counteract the global recession the federal reserve and 11 European countries lowered interest rates

15. September 11, 2001 • After a decade of growth and prosperity the U.S. would again face a time of trial • After the attacks the Fed cut interest rates and President Bush cut taxes to pull the U.S. out of a short recession • The tax cuts again put the U.S. in a major current account deficit of 6.5% of GDP • The dollar began to depreciate against the Euro

16. Credit Markets • In 2007 the credit markets of the industrial world faced much instability. • The roots of the crisis were in the home mortgage market • The low interest rates caused a rise in home prices in the U.S. • The mortgage industry began to give riskier loans to people who would not otherwise qualify

17. Interest Rates • The interest rates were low in the period of 2003 to 2005 • They abruptly rose in 2006 and 2007 • This rise made many people unable to pay their mortgage payments • Now the lenders could not find anyone to make loans to them. So the Fed dramatically cut interest rates to fight off a recession. • The cut of the interest rate caused a large depreciation of the dollar • The current account deficit should have caused the interest rates to rise, but the interest rates actually fell • This occurred because foreign countries had enough global savings to cover our deficit. Since our deficit was offset by a large amount of savings, this caused the interest rates to fall.