Question

Please explain in extensive detail what happens to the value of the dollar if the European Central Bank (ECB) does quantitative tightening to the money supply? How will this impact the value of the dollar, exports and imports, AD and GDP? Please provide a graph explaining your reason.

Answer 1

The Fed in the US and the ECB in Europe are reversing their ‘easy money’ policies, because they think that the US and Eurozone economies are strong enough to stand on their own. It has taken 10 years, but economic markers are now being dubbed healthy enough to begin a long period of ‘unwinding’. The ECB confirmed in a statement on June 14th it would end QE bond purchases by December, while the Fed has already started unwinding its massive balance sheet after ending QE and is raising interest rates as both banks move to ‘normalise’ monetary policy.

Four other factors also bear watching: 1) Interest rates will rise making equities relatively less attractive than bonds. 2) Companies, especially emerging market companies who have added $40trn of debt since the debt crisis will find it much harder to re-finance their bonds and loans in the capital markets. They will be competing for US dollar liquidity with the Federal Reserve. That will lead to more corporate insolvency and create pressure in the equity markets. 3) The US government has massively increased its budget deficit following tax cuts. That means that companies will be competing against both the Fed and the Treasury for liquidity. 4) The consequence of greater competition for dollar liquidity will mean a sharp rise in the value of the US dollar. This will have negative implications for US exporters and commodity producers creating further negative feedback for equity markets.

The US dollar, as the global reserve currency, which now accounts for about 70% of international trade transactions would diminish. If we net out the intra-regional trade in the Euro Zone which is conducted in euro, then the share of international trade conducted in the US dollar goes up to close to 90%. Furthermore, nearly every commodity is also priced in US dollar. Thus, a shrinking US economy in dollar terms means shrinking international trade. Shrinking exports by US also means that they will be able to import less from the rest of the world, leading to a downward spiral.