What if the US suddenly lost its position as the worlds reserve currency? A run on the US dollar will cause economic stagflation: as the dollar value falls the exchange rate will depreciate, causing inflation to increase and raising business costs which will lead to layoffs/ increased unemployment. Because current US domestic demand is driven by the borrowing of substantial foreign investment, available loanable funds will decrease, borrowing will constrain, and US demand and aggregate output will fall, consequently leading to financial market collapse and economic decline. Because of a large trade deficit, a depreciating exchange rate will cause inflation to subsequently rise as more dollars are needed to buy less, increasing the cost of imports. Unemployment will increase as consumption falls. The government will need to print money to maintain consumption, which will further devalue the dollar and cause runaway inflation.
In addition to being the world’s reserve currency due to historical US political and economic stability, foreign investors are attracted to the developed financial markets offering high liquidity. Large foreign capital accumulation can be costly as sterilization can cause the return on reserves to drop lower than the interest paid on issued bonds. Foreign investors with much government bonds will demand higher interest rates and start targeting other investments, such as debt, due to their relatively low risk, high liquidity, and steady returns. High foreign investment appreciates the exchange rate, increases a trade deficit, and may lead to an over-valuation of currency.
Suppose the US economy is operating under “normal conditions”— assuming 2.7% inflation, 5.8% unemployment, 3.8% economic growth. Which policy is more effective, fiscal or monetary? The Fed operates under the legal mandate to ensure stable growth and full employment. If these are the measures of “effective”, monetary policy should be more effective because it causes “immediate changes” in the money supply and interest rates, immediately combating inflation. If there are supply shocks, monetary policy best stabilizes prices. Under the assumption of the Taylor Rule, monetary policy achieves its goals by adjusting target inflation rates and federal funds/ discount rate with tools such as open market operations and quantitative easing which alter the money supply. Under rational expectations, if the Fed announces higher inflation in the future, consumption should increase now and unemployment decreases. Because consumers are not rational and prices are sticky, changes in the money supply do not immediately impact the consumption, so there is a multi-month lag in response. However, a zero-bound funds rate has the same effect as a contractionary supply shocks, so while it may stimulate consumption, it may be detrimental to welfare.
Fiscal policy requires legislation and implementation which takes time to impact the economy. Taxes will not respond quickly enough to a supply shocks, and subsidies not not evenly distribute the benefits due to crowding.
Also, despite decreases in prime rates and large denominated CD rates, credit card rates are very sticky and do not respond accordingly due to habit forming consumption. If an economy possess much revolving credit that drives consumption, monetary policy may not be most effective for increasing welfare, but instead benefit lenders.
William Dare 