The Subprime Crisis and the Dollar
With the start of the subprime financial crisis in August 2007, the dollar began an accelerated decline in value, falling by 9% against the euro until mid July of 2008, and 6% against a wider basket of currencies. After hitting an all time low against the euro on July 11, the dollar suddenly shot upward, by over 20% against the euro by the end of October and 15% against a wider basket of currencies. What is the relationship between the subprime crisis and these large swings in the value of the dollar? During 2007, the negative effects of the subprime crisis on economic activity were mostly confined to the United States. The Federal Reserve acted aggressively to lower interest rates to counter the contractionary effects, decreasing the federal funds rate target by 325 basis points from September of 2007 to April of 2008. In contrast, other central banks like the ECB did not see the need to lower interest rates, particularly because high energy prices had led to a surge in inflation. The relative expected return on dollar assets thus declined, shifting the demand curve for dollar assets to the left, as in Figure 15.5, leading to a decline in the equilibrium exchange rate. Our analysis of the foreign exchange market thus explains why the early phase of the subprime crisis led to a decline in the value of the dollar. We now turn to the rise in the value of the dollar. Starting in the summer of 2008, the effects of the subprime crisis on economic activity began to spread more widely throughout the world. Foreign central banks started to cut interest rates, with the expectation that further rate cuts would follow, as indeed did occur. The expected decline in foreign interest rates then increased the relative expected return of dollar assets, leading to a rightward shift in the demand curve, and a rise in the value of the dollar, as shown in Figure 15.4. Another factor driving the dollar upwards was the “flight to quality” when the subprime financial crisis reached a particularly virulent stage in September and October. Both Americans and foreigners now wanted to put their money in the safest assets possible: U.S. Treasury securities. The resulting increase in the demand for dollar assets provided an additional reason for the demand curve for dollar assets to shift out to the right, thereby helping to produce a sharp appreciation of the dollar.