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American economy is influencing the world economy as never before and particularly the Asian developing nations which are increasingly becoming dependent on GDP growth fuelled by $ based trading. The present American recession pushed the US interest rate down to almost zero. However, the crisis didn't require similar cut back in interest rates for other economies. Though we saw strong measures to increase liquidity in developing nations. Why were the interest rates cut down so much and increased liquidity was ensured through various means. Why did it all happen and why in this large proportion? Was it only to fight liquidity crunch in the domestic market of developing nations? No, the reasons are not so simple. There was another very important factor playing a role. "Developing nations dependence on Dollar based world trade".

As lowering interest rates in US devalued the dollar, developing countries like India had to follow suite. Developing nations had to make a choice between stable exchange rate and domestic inflation. Most of the nations chose to maintain their currency against dollar rather than to maintain a stable domestic inflation rate. In doing so, almost every developing nation increased the flow of domestic currency in the local market, but this was done not only to fight credit crunch but to match the falling dollar as well. The extra bit of effort made to maintain the value of dollar cost the countries a recent surge in inflation.

Well, free market economy is all about choices. The developing economies chose to defend dollar to maintain their cost advantage but in the process stoked inflation which will anyways hurt export. The question is which would have hurt more? A weaker dollar or domestic inflation?

Please write in your views.

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Thanks for your remarks. I love the subject too. Inflation is all over the world and not only in India. My colleague in the US is claiming that prices are going through the roof (even though according to statistics inflation in the US is not at a level that should worry the FED) and here in Moscow where I live I can tell you that food prices are increasing by the day. It sounds quite logical that if they have poored tons of liquidity in the market it will create inflation but why statistics do not seem to reflect it is the question I ask ...
The second question I ask is why are the main goals of political economy stuck on exporting? Why holding foreign currency is better than building up the countries' assets? Why holding US dollars in some electronical account is better than building schools and roads, strong balanced agriculture and maybe some cultural activities?
Inflation is reflected in statistics.. but thr is a lag... but its showing quite well in India...
I don't know the figures in US but in UK the inflation hasn't come yet...

ur 2nd question...
The primary reason for holding US $ is to pay for your imports... yes an excess US $ can b used for domestic growth however, the gov has to be very cautious... if u start converting ur $ to local currency, then $ will lose its value and ur local currency will appreciate... gov. of developing countries don't want that as it hurts the export... it also means tht ur remaining Dollar reserves will its lose value..
China has come up with an unique solution... China holds d max US Dollars outside US... They have made a sovereign fund and invests in assets outside China... thus trading still in $ but making good use of their reserves. Its one of the biggest sovereign fund in the world.
One of the biggest flaw in the whole free market economy is that the withdrawal of Gold Standards of the currency. Had the currencies of the world, or in this case dollar, had been backed by the gold, then the inflation would have been a problem to a lesser degree for any country who holds dollar as its main trading currency as the true monetary value of the currency is backed by a commodity (gold) which can be withdrawn or transferred to other liquid means.

More realistically, at the present situation, domestic inflation is desirable over weak dollar. Many Western economy lacks business confidence because of very low domestic inflation for which demand in the economy is weak. If domestic inflation is permitted for the time being, then the demand and the business confidence will remain persistent and the impact of the financial meltdown will take much longer to affect the economy.
Rightly said Ahmed. You are dead right on both the things you mentioned.
The only problem with gold backed currency is that it takes away the power of monetary policy from the hands of central bank.
Yes, Bhasker, theoretically the problem of the gold backed currency is that it takes away the power of monetary policy from the hands of central bank. However, it can be argued that most economies until 1970s, which had used gold standards, had made their central bank the sole legal tender to issue money. So as these central banks were the sole legal issuer of the money, they can have a great hand over the monetarist policy.

The biggest problem of the gold backed currency in my opinion for now is that we simply don't have enough gold to finance the world's economy! The world economy is valued approximately around 8 trillion US dollars now, and throughout the history, the total value of the gold mined is valued at modern time is about 4.5 trillion US dollar. So this leaves the deficit of gold at about 3.5 trillion US dollar. Still, it can be argued that the value of the gold can be inflated, but in practical terms, that would lead to a hyper inflation of gold's value and thus lead to an overall rapid inflation in short run.
:) rightly said. Great piece of info!
Good point Phil. May be that is why the export driven economy of China didn't see that inflation inspite of the dollar pegging. However, India with a strong domestic demand couldn't resist the pressure of inflation after matching its currency against USD.


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