Research

It is ironic that the dollar has strengthened rather than weakened over the last year. The sub-prime mortgage crisis originated in the United States; The crisis has severely undermined the credibility of American financial institutions -- both in the narrower sense that leading investment banks have now disappeared and in the broader sense that American modes of corporate governance have lost value as role models (rating agencies, accounting systems, executive compensation, and so on) The response in Washington has included further acceleration in the already-rising national debt plus an expansion of the US money supply and reduction in policy interest rates that, though appropriate, are unprecedented.

The possibility that some Gulf states, particularly the United Arab Emirates, might abandon their long-time pegs to the dollar has been getting increasing attention recently (for example, from Feldstein and, especially, Setser). It makes sense. The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries.

Menzie Chinn, Prof. of Economics at University of Wisconsin, is guest posting this week: I want to thank Jeff Frankel for the opportunity to be a guest writer on his blog. A lot of attention has been devoted to how oil price and food price shocks have affected the US economy, both along the output and price dimensions. A general presumption has been that as long as inflation expectations remain well anchored, then one need not worry about 1970’s style stagflation (recession is another matter). However, there are many places in the world where inflation expectations are not well anchored.