Fundamentals of Financial Management (Concise 6th Edition)

184 Part 3 Financial Assets

would lower the value of the dollar relative to other currencies, which would make

U.S. goods less expensive, which would help manufacturers and thus lower the

trade de! cit. Note also that during periods when the Fed is actively intervening in

the markets, the yield curve may be temporarily distorted. Short-term rates may

be driven below the long-run equilibrium level if the Fed is easing credit and above

the equilibrium rate if the Fed is tightening credit. Long-term rates are not affected

as much by Fed intervention.

6-7b Federal Budget Deficits or Surpluses

If the federal government spends more than it takes in as taxes, it runs a de! cit;

and that de! cit must be covered by additional borrowing (selling more Treasury

bonds) or by printing money. If the government borrows, this increases the demand

for funds and thus pushes up interest rates. If the government prints money, inves-

tors recognize that with “more money chasing a given amount of goods,” the result

will be increased in" ation, which will also increase interest rates. So the larger the

federal de! cit, other things held constant, the higher the level of interest rates.

Over the past several decades, the federal government has generally run large

budget de! cits. There were some surpluses in the late 1990s; but the September 11,

2001, terrorist attacks, the subsequent recession, and the Iraq war all boosted gov-

ernment spending and caused the de! cits to return. It is dif! cult to tell where! scal

policy will go and consequently what effect it will have on interest rates.

6-7c International Factors

Businesses and individuals in the United States buy from and sell to people and

! rms all around the globe. If they buy more than they sell (that is, if there are more

imports than exports), they are said to be running a foreign trade de" cit. When

trade de! cits occur, they must be! nanced; and this generally means borrowing

from nations with export surpluses. Thus, if the United States imported $200 bil-

lion of goods but exported only $100 billion, it would run a trade de! cit of

$100 billion while other countries would have a $100 billion trade surplus. The

United States would probably borrow the $100 billion from the surplus nations.^15

At any rate, the larger the trade de! cit, the higher the tendency to borrow. Note

that foreigners will hold U.S. debt if and only if the rates on U.S. securities are

competitive with rates in other countries. This causes U.S. interest rates to be

highly dependent on rates in other parts of the world.

All this interdependency limits the ability of the Federal Reserve to use mone-

tary policy to control economic activity in the United States. For example, if the

Fed attempts to lower U.S. interest rates and this causes rates to fall below rates

abroad, foreigners will begin selling U.S. bonds. Those sales will depress bond

prices, which will push up rates in the United States. Thus, the large U.S. trade

de! cit (and foreigners’ holdings of U.S. debt that resulted from many years of de! -

cits) hinders the Fed’s ability to combat a recession by lowering interest rates.

For about 25 years following World War II, the United States ran large trade

surpluses and the rest of the world owed it many billions of dollars. However, the

situation changed, and the United States has been running trade de! cits since

the mid-1970s. The cumulative effect of these de! cits has been to change the United

States from being the largest creditor nation to being the largest debtor nation of all

time. As a result, interest rates are very much in" uenced by interest rates in other

Foreign Trade Deficit

The situation that exists

when a country imports

more than it exports.

Foreign Trade Deficit

The situation that exists

when a country imports

more than it exports.

(^15) The de# cit could also be # nanced by selling assets, including gold, corporate stocks, entire companies, and real
estate. The United States has # nanced its massive trade de# cits by all of these means in recent years. Although
the primary method has been by borrowing from foreigners, in recent years, there has been a sharp increase in
foreign purchases of U.S. assets, especially oil exporters’ purchases of U.S. businesses.