A wrong explanation for the drop in the value of the dollar

SAN FRANCISCO (MarketWatch) -- The dollar dropped across the board Friday, marking the seventh straight trading session in which it's sunk to a record low against the euro, after tame core inflation data suggested that the Federal Reserve has room to further cut interest rates. . . .

People make investments based upon the real (after inflation) return that they expect on an investment. If the interest rate simply fell by the drop in inflation, the real return for holding dollars would be unchanged. There is however something known as the "Darby effect" that could explain what is happening. Our government taxes the nominal interest that we get, not the real interest rate. As the inflation rate rises, interest rates have to rise by more than the increase in inflation to compensate lenders for the higher taxes that they will have to face. So a drop in inflation results in an even bigger drop in interest rates. Even so, the real after tax return from holding dollars should be remaining the same. In any case, I am pretty dubious that the small amount of money that the FED loans to banks is really driving interest rates very much. I haven't spent a lot of time figuring what is happening right now with respect to changes in the value of the dollar, but I know that this explanation is wrong.

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Blogger Dad29 said...

There are some who state that USD is "weakened" by the printing-press mentality of Bernanke & Co.--

And long-term rates have moved up following the Fed's move.

9/29/2007 8:32 AM  

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