Wednesday, December 05, 2007

Macroeconomics review class

Professor Galbraith predicted that if the Democratic Party finally takes over control, they would adopt expansion monetary policy (banking policy). Since the fiscal policy is kinda fixed, which because the US government has spent too much money that they can not expand the government expenditure anymore, the only choice for them is to cut interest rate to move the LM curve to the right, thus to increase the national income. (It is exactly happening now as well. The Federal Reserve cuts interest rates and devaluate the Dollar in order to push the economy development. Democratic Party would push it even further, since it focuses more on domestic economy).

However, the system does not function all by itself and it would in turn induce a series of effect. Because the national income increases, people would buy more goods from abroad, which means the increase of import. In order to catch up the increase of import and bring the trade deficit back to balance, the Federal Reserve needs to cut the interest rates again to promote export. The outcome is the interest rates would be so low that investment in the U.S is not profitable at all, which means the further devaluation of Dollar. So, if people stop invest in the U.S. or withdraw their money, which mean sell their assets in the U.S. , it would be a big disaster for the U.S. and destroy the financial system and even the whole economy , which is based upon the capital flow and investment.

So, what is the solution? Try to work with other countries to persuade them to hold dollar not dump dollar. Specifically, the U.S. needs to bilaterally negotiate with the large institutions, which namely are UK, EU, Japan, and China, to hold dollar, then the money invested in the U.S. can hold, as the economy recovers( I noticed that he used recover, which indicates the U.S. economy in fact is recessing , not big recession though), the U.S. would have more liquidity.

But, would it work out? What does the U.S. need to work it out? That’s credibility. Does the U.S. have it? Given the 7years foreign policy adopted by Bush Administration and the crisis of the domestic housing market, how much credibility the U.S. still holds is not a question.

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