Effects of the Current Divergent Monetary Policies of the Fed and Ecb on Forex and Capital Flows

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Effects of the current divergent monetary policies of the Fed and ECB on FOREX and capital flows

International Money

1. Introduction

It’s the end of April 2011 and the world seems to be turning upside down. The current never-ending  financial crisis started with bad mortgage debt, spread to bad bank debt, carried over into bad agency debt, and now encompasses bad sovereign debt. On top of everything, natural disasters like the recent Japanese earthquake are putting even more pressure on macroeconomic policy-makers. Our essay will analyse the impact on the FOREX market and capital flows of the latest monetary policy choices of the Fed and ECB and the broader consequences for the Eurozone and the US. We chose to focus on the US and Eurozone since they have the world’s two biggest central banks, they both have floating exchange rates and their currencies are the most traded on FOREX, meaning that shifts in the supply or demand of Euros and/or Dollars will have strong effects on capital flows. We will be considering the Eurozone as a whole since our focus is on interest rates, which are set according to the common monetary policy of ECB.

2. Current framework and motivation for policy choices

In the current situation of global instability, we are also facing a worldwide rise in consumer and oil prices. This follows the extended period of loose monetary policies of national banks around the world, which were undertaken in order to foster economic recovery. In this context it is very difficult to decide the path of the monetary policy since too early a policy tightening could hamper the recovery achieved, while keeping the policy too loose for too long will give rise to severe inflation. Both Eurozone and the USA are experiencing a similar moderate economic growth. Still, we see that they are going in opposite directions. In Eurozone, the economy took off in 2010. There was 0.3% quarter-on-quarter increase in real GDP in the 4th...
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