From Paul Krugman's NYT blog today:

First, we need a model. My starting point is to think of the Fed as setting “the” interest rate (more on that later), and facing two tradeoffs. On one side, the lower the interest rate the higher is employment. On the other side, the lower the interest rate the lower the dollar. In normal times the Fed tries to set the interest rate so as to achieve more or less full employment, and lets the dollar fall where it may.

Now along comes a change in investor expectations that makes the dollar weaker at any given interest rate. This also, with some lag, makes the economy stronger at any given interest rate, because a weaker dollar means stronger exports and less imports.

So what would we expect the effect of changing expectations that weaken the dollar to be? We’d expect it to lead to a weaker dollar (duh) and also higher interest rates — but the latter effect would happen only because the Fed is trying to offset the expansionary effect of that weaker dollar. It shouldn’t depress the economy at all.

OK, so how do we make this story more pessimistic?

Full post here.