Order Code RL31985
CRS Report for Congress
Received through the CRS Web
Weak Dollar, Strong Dollar:
Causes and Consequences
Updated July 30, 2004
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Weak Dollar, Strong Dollar: Causes and Consequences
Summary
After a long and large appreciation, in early 2002, the dollar peaked and has
since then steadily weakened in value relative to other major currencies. A weaker
dollar will be good news for exporters and those who compete with imports, while
consumers of imports will be correspondingly unhappy. Yet it is important to
recognize that a falling dollar is symptomatic of the ebb and flow of international
capital in and out of the American economy. Those flows will have important
implications for domestic interest rates and activities sensitive to credit conditions,
such as housing and business investment.
The exchange rates movement will be strongly influenced by the effect of
changes in interest rates on the flow of financial capital between countries. One also
needs to consider how the expected movement of future exchange rates influences
investors now. Inflation, safe-haven and speculative effects, and the size of the trade
balance can also be important.
The central role of relative interest rates in generating international capital flows
and exchange rate movements makes it important to understand the forces that move
interest rates. This points us toward an understanding of the demand for and supply
of loanable funds. The economy’s pattern of saving and investment will exert a
strong force on interest rates. For the United States, a structural tendency for
domestic savings to fall short of domestic investment leads to significantly higher
interest rates when economic activity picks up speed. Government policy can also
affect interest rates and the exchange rate. Large government budget deficits will tend
to push up interest rates and the exchange rate. Budget surpluses have the opposite
effect. Tight monetary policy tends to raise interest rates and the exchange rate. A
stimulative monetary policy has the opposite effect. Recent U.S. economic history
has demonstrated the great importance of these fundamental factors in determining
the exchange rates path.
As we contemplate the significance of a weakening dollar, it is important to
consider the effect of the outflow of foreign capital that causes that weakening on
domestic investment and overall economic welfare. In the 1980s, macroeconomic
policy had a substantial effect on the level of interest rates and the path of the dollar.
Tight monetary policy and large budget deficits pushed interest rates and the dollar
upward through 1985 and a reversal of those policies pushed interest rates and the
dollar down over the last half of the decade. In the 1990s a steady rise of the dollar
from mid-decade on was primarily the consequence of an investment boom in the
United States that kept rates of return high and attracted large inflows of foreign
capital. In both of these periods upward pressure on the dollar was intensified by a
persistently low U.S. saving rate and relatively weak economic performance abroad.
The depreciation of the dollar since 2002 is likely the consequence of slower U.S.
growth and a move toward a more diversified portfolio by foreign investors. The
dollar’s near-term path is problematic, but important forces seem poised to put
significant upward pressure on the dollar.
This report will be updated as events warrant.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
What Determines the Dollar’s Exchange Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Demand, Supply, and the Dollar Exchange Rate . . . . . . . . . . . . . . . . . . . . . . 2
The Importance of Trade in Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Expected Rate of Return and Asset Flows . . . . . . . . . . . . . . . . . . . . . . . 4
Diversification, Safe-Havens, and Asset Flows . . . . . . . . . . . . . . . . . . . 5
Fundamental Factors Determining the Level of Interest Rates . . . . . . . . . . . . . . . 7
Capital Inflows, an Appreciating Dollar, and a Rising Trade Deficit . . . . . . . . . . 9
The Ups and Downs of the Dollar: 1980 to 2003 . . . . . . . . . . . . . . . . . . . . . . . . 10
The 1980s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
The 1990s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
The 2000s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Instability and the Prospect of a Dollar Crash . . . . . . . . . . . . . . . . . . . . . . . 12
Where Will the Dollar Go . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Economic Policy and the Ups and Downs of the Dollar . . . . . . . . . . . . . . . . . . . 15
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

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Weak Dollar, Strong Dollar:
Causes and Consequences
Introduction
From 1994 to early 2002 the real(inflation adjusted) trade-weighted dollar
exchange rate appreciated nearly 30%.1 Since that peak, the dollar has, more or less,
steadily depreciated and in mid- 2004 is about 10% below the 2002 level. This fall
has been far from uniform against individual currencies. For example, the dollar has
fallen twice as much against the euro as it has against the yen and has not declined
at all against the yuan. These differences are largely a refection of the degree to
which these countries have used policy to resist their currencies appreciating relative
to the dollar.
The strong dollar in the 1994-2002 period was certainly a benefit to U.S.
consumers of imports as the rising exchange rate substantially lowered the price of
foreign goods relative to the price of competing domestic products. But the
appreciating dollar was a rising impediment to the sales of U.S. exporting and import
competing industries as the price of their products increased relative to those of
foreign competitors. And as the dollar rose so did the U.S. trade deficit. Therefore,
we can expect a weakening dollar to be celebrated by exporters and lamented by
domestic consumers. We can also expect sustained dollar depreciation to reverse the
steady rise of the U.S. trade deficit.
The dollar is not just moving on its own, but is being propelled by some
fundamental economic forces. It is important to understand that movements of the
dollar are most often symptomatic of the ebb and flow of international capital in and
out of the United States, and that these asset market events can also have strong
effects on the U.S. economy. Asset market transactions most often occur at a higher
volume and at greater speed than do transactions in goods (i.e., imports and exports).
Because of this most economists would argue that it is events in international asset
markets that “call the tune the dollar dances to.”
This will mean that the net size of these asset flows will generally dictate the
position of a country’s trade balance. A country receiving a net inflow of foreign
capital will have an appreciating exchange rate and run a trade deficit. A country
generating a net outflow of foreign capital will have a depreciating currency and run
a trade surplus. The exchange rate moves to equilibrate the inflow with the outflow
of goods and assets. This also tells us that because the ups and downs of the dollar
are driven by asset flows in and out of the economy, these dollar movements will be
1The trade-weighted exchange rate index used is the price-adjusted broad dollar index
reported monthly by the Board of Governors of the Federal Reserve System.

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associated with impacts on domestic credit markets, affecting domestic interest rates
and, in turn, interest sensitive spending such as housing, consumer durables, and
business investment. Thus, while a rising dollar may be bad news for the tradeable
goods sector it is likely good news for interest rate sensitive sectors and vice versa
for a falling dollar.
The importance of U.S. international economic transactions to a healthy
economy is well recognized by Congress, which in recent years has closely monitored
many dimensions of U.S. trade performance. The dollar exchange rate, cross border
financial flows, and the trade deficit are known to be important to the functioning of
the U.S. economy and for the implementation of sound economic policy. They are
therefore issues of congressional concern. This report provides background
information on the forces that most likely determine the path of the dollar exchange
rate. The report also considers recent events in international markets for goods and
assets as well as suggest what implications these forces carry for the state of the U.S.
economy and for economic policy.

What Determines the Dollar’s Exchange Rate

The exchange value of the dollar is determined by the interplay of the demand
for and supply of dollars in global foreign exchange market. Prior to 1973, in the so
called “fixed exchange rate” era, the dollar’s value was fixed at a rate established by
international agreement, and the U.S. government was actively involved in
maintaining that fixed rate. The fixed rate exchange rate regime grew increasingly
untenable in part because of the growing size and mobility of capital flows between
countries. In the early 1970s, the U.S. and many other nations changed by default to
a “flexible exchange rate” system that endures today.2
Demand, Supply, and the Dollar Exchange Rate
With flexible exchange rates and wide-spread abandonment of capital controls
the dollar is largely free to move up or down as market forces dictate. In most
circumstances the government plays little or no direct day to day role in determining
the dollar’s value relative to other currencies. The government can certainly use
macroeconomic policy to affect the market forces that determine the exchange rate,
but instances where the primary policy goal is the exchange rate are relatively rare.
The exchange rate is almost always subordinate to the goal of domestic economic
stabilization.3 But the exchange rate will certainly move as a collateral consequence
of pursuing other economic goals. On occasion, governments will intervene directly
in the foreign exchange market, buying or selling particular currencies to induce
2 For a discussion of the collapse of the fixed exchange rate regime, often called the Bretton
Woods System, see Barry Eichengreen, Globalizing Capital, (Princeton, New Jersey:
Princeton University Press, 1996), pp. 93-124. Currently about half of IMF member
countries allow their currencies to float.
3Many would argue that the great virtue of floating over fixed exchange rates is that in that
regime the monetary authority, free from the need to use monetary policy to maintain the
fixed rate, can make domestic stabilization its primary focus.

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some adjustment of the exchange rate, but such interventions are also infrequent and,
when used, their impact on the exchange rate is often problematic unless the
intervention is supported by changes in macroeconomic policy.
In this framework it is reasonable to infer that any observed weakening or
depreciation of the dollar is most likely the result of a reduced demand for dollars in
the foreign exchange market, an increased supply of dollars in that market, or some
combination of both forces. Similarly, an appreciating, or strong dollar, is the
consequence of an increase in the demand for dollars, or a decreased supply of
dollars, or both in the foreign exchange markets. And most often these changing
market forces are the result of actions by private market participants rather than
government policy.
The demand for dollars for use in international exchange is a derived demand,
driven by foreigner demand for U.S. goods and assets, which of course are
denominated in dollars and can only be purchased with dollars. Therefore, to
purchase U.S. goods or assets, a foreign buyer must first exchange their home
currency for dollars. Transactions in the foreign exchange market do not involve the
transfer of large parcels of paper currency between countries. These exchanges are
most often speedily achieved by the shifting of electronic balances between
commercial banks or foreign exchange dealers. With the purchase of a U.S. good or
asset there has also been an increase in the demand for dollars and an increase in the
supply of foreign currency in the foreign exchange market. Other factors unchanged,
these actions repeated on a larger scale would tend to increase the exchange value of
the dollar relative to foreign currency. That is, the dollar will appreciate, meaning that
each dollar can be exchanged for a greater amount of foreign currency, and as a result
command a greater volume of foreign goods or assets.
Similarly, when Americans buy foreign goods or assets they initiate a similar
process; however, it will have the opposite effect on the dollar’s exchange value.
Exchanging dollars for a foreign currency represents an increase in the demand for
foreign currency and an increase in the supply of dollars on the foreign exchange
market. This type of transaction repeated on a larger scale would tend to depreciate
the exchange value of the dollar relative to foreign currencies, causing each dollar to
exchange for less of the foreign currency, and as a result to command a smaller
volume of foreign goods or assets.
The salient point is that the relative strength or weakness of the dollar will
depend on the relative strength or weakness of the demand of foreigners for dollar
denominated goods and assets in comparison to the strength of U.S. demand for
foreign goods or assets.
The Importance of Trade in Assets
Looking more closely at the dynamics of world trade today we see that the
volume and speed of international asset transactions far exceeds that of goods

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transactions.4 As in the foreign exchange market, a very large share of asset
transactions can be done electronically and therefore move far more rapidly than do
goods, which will most often require a slower physical transfer. This means that at
any given point in time it is most likely that the relative demand for assets here and
abroad will be the dominant force in the foreign exchange market, transmitting the
essential energy that drives movement in the exchange rate for the dollar and other
widely traded currencies.
Expected Rate of Return and Asset Flows. What determines the size
and direction of cross-border asset flows? We can expect that the demand for assets
(e.g., bank accounts, stocks, bonds, and real property) by foreigners will be strongly
influenced by the expected rate of return on those assets. The level of nominal
interest rates can be used as a fairly reliable first approximation of the rate of return
on assets that can be earned in a particular country. Therefore, differences in the
level of interest rates between economies are likely to animate and direct
international capital flows, as investors seek the highest rate of return. When interest
rates in the United States are significantly higher than interest rates abroad, the
demand for U.S. assets will, other factors unchanged, strengthen the demand for
those assets, increase the demand for the dollars needed to buy U.S. assets, and
appreciate the value of the dollar relative to foreign currencies. In contrast, if interest
rates in the United States are on average lower than interest rates abroad, the demand
for foreign assets will likely strengthen and the demand for U.S. assets will likely
weaken. This will cause the demand for foreign currencies needed to purchase
foreign assets to strengthen and the demand for the dollar will weaken, leading to a
depreciation of the dollar relative to foreign currencies.
Yet differences in nominal interest rates may not be all an investor needs to
know to guide her decision. One must also consider that the return actually realized
from an investment is paid out over some future period. This means that the realized
value of that future payment can be altered by changes in other economic variables.
Therefore, investor expectations of those future events will influence the investors
“expected pay off” and, in turn, the relative attractiveness of an asset. Two economic
variables of particular relevance to this decision are the expected change in the
exchange rate itself over the term of the investment and the expected rate of inflation.

Expectations about the future path of the exchange rate itself will figure
prominently in the investor’s calculation of what she will actually earn from an
investment denominated in another currency. Even a high nominal return would not
be attractive if one expects the denominating currency to depreciate at a similar or
greater rate and erase all economic gain. On the other hand, if the exchange rate is
expected to appreciate the realized gain would be greater than what the nominal
interest rate alone would indicate and the asset looks more attractive.
The influence of exchange rate expectations can significantly complicate the
task of judging how exchange rates will move, as we can only imperfectly assess
4For a discussion of the tremendous growth of cross-border asset transactions, see CRS
Report RL30514, Global Capital Market Integration: Implications for U.S. Economic
Performance, by Craig K. Elwell.

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what informs those expectations and the strength of their effect. It is also possible for
exchange rate expectations to introduce some degree of volatility into the exchange
rate system, as “speculation” by some investors on the future path of the exchange
rate can push the currency, up or down, as speculative actions feed on each other and
generate “herd like” behavior. In these situations exchange rate expectations become
a sort of self-fulfilling prophecy that works to exaggerate the path the currency is
already set upon, pushing the currency well beyond what more basic fundamentals
alone would dictate.
But this is going to be a bounded process. For at some point this speculative
motive will also likely work to counter the ongoing trend, as the risk vs. reward
calculus causes a growing number of traders to doubt the likelihood of the dollar
moving further on its current path and to come to believe that depreciation is the
more probable event. As you might expect, such speculative behavior often makes
it difficult to accurately predict the magnitude and duration of exchange rate
movements, particularly in the short run.
The impact of expected inflation on investor decisions is more indirect. To a
foreign investor, the U.S. rate of inflation would have little direct effect on his
expected rate of return from a dollar denominated asset. The critical uncertainty for
him is the path of the exchange rate, which will determine how any given dollar
return will translate into his own currency. However, relative inflation rates among
nations can be a predictor of where and how much the exchange rate will move in the
future and, therefore, potentially relevant to the foreign investor’s assessment of his
expected return. If the United States has a lower inflation rate than that of a trading
partner, the dollar can be expected to appreciate relative to that currency by an
amount necessary to maintain parity in real purchasing power. If the United States
has the higher rate of inflation, then the dollar would tend to depreciate so as to
maintain real purchasing power. In other words inflation differences will change the
nominal exchange rate but not the real exchange rate.
Another reason inflation may influence the demand for assets is that trends in
the level of prices can be a telling indicator of how well or poorly an economy is
managed and whether the investment climate will change for better or worse.
Economies with accelerating inflation are more likely to be ones that are poorly
managed, with poor investment prospects; while economies with stable or
decelerating inflation may be seen as better managed and likely a more attractive
destination for investment. The aggressive and successful U.S. dis-inflation policy
in the early 1980s may have contributed to the dollar’s sharp appreciation in this
period. In recent years inflation in the United States has been consistently low and
the current posture of the Fed gives us no reason to believe that this pattern will
change, making this factor of diminished importance for judging recent and
prospective movements of the dollar exchange rate. Changes in inflation trends in
other countries will still be a factor, however.
Diversification, Safe-Havens, and Asset Flows. While relative levels
of interest rates between countries and expected return are likely to be a strong and
prevalent force directing capital flows among economies, other factors will also
influence these flows at certain times. For instance, the size of the stock of assets in
a particular currency in investor portfolios can cause a change in investor preferences.

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We know that prudent investment practice counsels that one’s portfolio should have
an appropriate degree of diversification, across asset types, including the currency
in which they are denominated. Diversification spreads risk across a wider spectrum
of assets and reduces over exposure to any one asset. Therefore, even though dollar
assets may still offer a high relative return, if the accumulation has been large, at
some point foreign investors, considering both risk and reward, will decide that their
portfolio’s share of dollar denominated assets is large enough. To improve the
diversity of their portfolios, investors will slow or halt their purchase of such assets.
Given that well over $8 trillion in U.S. assets are now in foreign investor portfolios,
diversification may be an increasingly important factor governing the behavior of
international investors towards dollar assets.
There is also likely to be a significant safe-haven effect behind some capital
flows. This is really just another manifestation of the balancing of risk and reward
by foreign investors. Some investors may be willing to give up a significant amount
of return if an economy offers them a particularly low risk repository for their funds.
In recent decades the United States, with a long history of stable government, steady
economic growth, and large and efficient financial markets can be expected to draw
foreign capital for this reason. The size of this effect is not easy to determine, but the
disproportionate share of essentially no risk U.S. Treasury securities in foreign
holdings suggests the magnitude of safe-haven motivated flows is probably
substantial and must exert a bias towards capital inflows and upward pressure on the
dollar.
Given the importance of expectations in decision making and the speed with
which many asset transactions can occur, exchange rates can be volatile and
predicting the magnitude and duration of short-run exchange rate movement with
precision is a very elusive goal. But broad, long-term trends can most often be
explained by assessing the fundamental macroeconomic forces that affect the relative
level of interest rates and the expected rate of return between the U.S. and the other
major economies.5
5The issue of exchange rate volatility has been the focus of much discussion among
economists. Contrary to expectation, exchange rates have been much more volatile since the
demise of the Bretton Woods system. There are two principal explanations. There is an
inherent tendency for “overshooting” of equilibrium in these markets or exchange markets
are subject to large scale “destabilizing speculation.” For the creators of the Bretton Woods
system the deleterious effects of destabilizing speculation were thought to be substantial and
an important reason for not allowing exchange rates to float. In recent years, the locus of
opinion has shifted more toward the destabilizing speculation explanation as evidence of
investor irrationality has accumulated. The effect of volatility on the prices and volumes
of goods in world trade seems to have been small, however. The enhanced ability to hedge
exchange rate risk in modern markets may explain this small effect. We can expect that
economies with large trade sectors, such as those in Europe, will find volatile exchange rates
more disruptive than will economies with relatively small trade sectors, such as the United
States. Yet, whatever costs exchange rate volatility does cause must be balanced against the
considerable benefits of liberalized international capital flows.

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CRS-7
Fundamental Factors Determining
the Level of Interest Rates
Changes in the level of interest rates are usually central to understanding
movement of the dollar’s exchange rate. So what factors are likely to move interest
rates up or down? Again, the level of interest rates is largely a market driven
phenomenon governed by the demand for and supply of loanable funds.
The Demand for Loanable Funds. On the demand side of the loanable
funds market we look for changes in the forces that commonly influence the use of
credit. A strong, briskly growing economy with rapidly expanding investment
expenditure can be expected to have a rising demand for loanable funds and exert
upward pressure on interest rates. In contrast, economic weakness and attenuated
investment opportunities would tend to exert downward pressure on interest rates.
In addition to the vigor of the private economy, the demand for loanable funds and
the level of interest rates can be influenced by the balance of the government budget.
Government budget deficits mean that the public sector must borrow to fully fund its
expenditures. Such borrowing is a demand for loanable funds and can certainly
influence the level of interest rates in the market. Any movement toward larger
budget deficits tends to exert upward pressure on interest rates and movement toward
smaller deficits would have the opposite effect. Of course, these outcomes will be
tempered by the economy’s position in the business cycle. In or just after a recession
when the demand for loanable funds is weak, these elevating effects on interest rates
would be nil, but would become increasingly manifest as an economic expansion
matures.
The Supply of Loanable Funds. Of primary importance on the supply side
of the market for loanable funds is the nation’s rate of saving. That flow represents
the portion of current income that the economy has diverted from spending on current
consumption and provides a supply of loanable funds, available to finance current
investment expenditures. For any given level of demand for loanable funds, we can
expect that a higher rate of saving would likely lead to a lower level of interest rates
than would a lower rate of saving. Domestic saving can be augmented by an inflow
of foreign saving. That is precisely what the capital inflows we have already talked
about are. But that inflow will be primarily a response to pressures and incentives
initially generated by the relative size of domestic saving and investment. And, of
course that response will move the exchange rate.
One of the more significant macroeconomic characteristics of the U.S. economy
to emerge over the last 25 years is the economy’s low and declining domestic saving
rate. That rate has fallen from about 20% of GDP in the 1970s to near 15% today.6
A persistently low saving rate creates a significant structural bias towards relatively
high interest rates during periods when economic activity and, in turn, the demand
for loanable funds is on the rise. As we might expect, in these periods the dollar
6 See CRS Report RL30873, Saving in the United States: How it Has Changed and Why it
is Important?, by Brian Cashell and Gail Makinen.

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exchange rate will likely rise, as an increased flow of foreign capital is attracted by
those relatively high interest rates.

Government can also influence interest rates from the supply side of the
loanable funds market. On the fiscal policy side, whereas budget deficits are an
absorber of saving, budget surpluses are government saving that augments the
economy’s supply of loanable funds. Therefore, any move toward larger budget
surpluses (or smaller deficits) will exert downward pressure on interest rates, while
smaller surpluses (or larger deficits) tend to increase interest rates. Monetary policy
can influence the level of interest rates through its governing of the financial
intermediation activities of the banking system. A large share of the nation’s saving
is channeled to borrowers by banks. By altering the reserve position of banks, the
monetary authority can alter the level of loanable funds they will have available for
extending credit and thereby the level of short-term interest rates. A restrictive
monetary policy tends to raise interest rates, while a expansionary monetary policy
tends to lower interest rates. We will also find that monetary policy, less encumbered
by administrative and political constraints, is in practice a more flexible tool than is
fiscal policy and will be used more often to implement macroeconomic policy,
particularly in the short run.
Government Currency Intervention. Government can try to influence
exchange rates more directly. Economic theory suggests that if international assets
are not seen by market participants as perfect substitutes and risk premiums vary
between assets, it is possible for the central bank to affect the exchange rate by
altering the asset composition of its and investor portfolios through the buying or
selling of foreign exchange. When this action is executed in a way that does not
induce a change in the money supply it is called “sterilized intervention.” Such
intervention has been used periodically by the United States and most other
industrial economies to attempt to stabilize or change the value of the exchange rate.
Over the years there has been a controversy over whether sterilized intervention by
itself is effective at inducing permanent changes in the exchange rate. The evidence,
though not unanimous, tells us that such intervention can be effective some times and
to some degree, but it remains far from a highly reliable tool.
It is most likely to work when it is used visibly, infrequently, in coordination
with complementary intervention by other nations, and when it is aimed at moving
the exchange rate in the direction that macroeconomic policy will be pushing the
exchange rate. As such, sterilized intervention is unlikely to be effective at moving
the exchange rate counter to where enduring market fundamentals would take it. In
other words, it is unlikely that intervention could have prevented the strong
appreciation of the dollar between 1994 and 2001. Similarly, in the current period
intervention is unlikely to be able to weaken the dollar if macroeconomic policy and
investor demand begin to push the dollar up.

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Capital Inflows, an Appreciating Dollar,
and a Rising Trade Deficit
One should also be mindful that as cross border asset flows move the exchange
rate, it has an impact on trade in goods. An appreciating dollar makes U.S. exports
more expensive to foreign buyers and imports less expensive to domestic buyers.
With net inflows of foreign capital and a rising exchange rate the trade balance will
move toward deficit as export sales weaken and import sales strengthen. The size of
the deficit in goods trade will generally be equal to the size of the net inflow of
foreign capital, with the dollar’s exchange rate working as the equilibration
mechanism.
This sequence makes sense if you consider that a net inflow of foreign capital
to the United States represents a net transfer of purchasing power from foreign
economies to the United States. However, that purchasing power is denominated in
a foreign currency and can be used only to purchase foreign goods. Of course, this
process works in the opposite direction for countries that have a net capital outflow.
They will experience a depreciating currency and a surplus in goods trade
commensurate with the size of the capital inflow. A net capital inflow means a
country has sold more assets to foreigners than it has purchased from foreigners or
is running a surplus in its asset account. By the same reasoning, a net capital outflow
will represent a deficit in its asset account. Thus, across both goods and assets
transactions trade is always balanced, a surplus in asset trade must balance a deficit
in goods trade, and vice versa.
As we might expect, those whose economic activities are sensitive to credit
market conditions and the level of interest rates will find the forces causing the
appreciating dollar to be favorable to their economic well-being. Similarly, those
who export or who must compete with imports will find these circumstances
unfavorable to their economic well being. It is often argued that the trade deficits
that accompany a strong dollar also tend to increase the prospect of the nation
implementing protectionist policies. Such policies do not change the forces causing
the net inflow of capital and, therefore, will not change the trade deficit, but
ultimately will impose costs on the economy that exceed any benefits gained.
As with most economic events, there are benefits gained from capital inflows,
but at some cost. The strong dollar and its attendant capital inflows was a valuable
support to domestic investment activity in the 1990s. Higher investment will boost
economic growth and improve economic well being. Without the capital inflow,
U.S. investment would have been lower and the future benefits to our living standard
reduced. Some of those benefits flow to foreigners who own U.S. assets, but the
economy is better off than it would be without the capital inflow. The salient point
is that the strength or weakness of the dollar is not necessarily a positive or a negative
event, but rather a manifestation of an underlying economic process that helps some,
hurts others, but on balance may often bring a net benefit to the overall economy.7
7For a fuller discussion of trade deficits, see CRS Report RL31032, The U.S. Trade Deficit:
(continued...)

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The Ups and Downs of the Dollar: 1980 to 2003
It is revealing to examine the general path of the dollar since the1980s in the
framework outlined above. In both the 1980s and the 1990s, the dollar soared to
record highs but for different reasons. It will also be revealing to see what caused the
dollar to fall.8
The 1980s
During the 1980s, the dollar exchange rate followed a path of sustained and
substantial appreciation followed by sustained and substantial depreciation. The
dollar actually began its ascent in 1979 in response to a sharp tightening of monetary
policy, which pushed up domestic interest rates. The Fed’s goal at this time was not
dollar appreciation, but to rein in the double digit inflation afflicting the economy.
Nevertheless, as the markets came to appreciate the Fed’s resolution in fighting
inflation and the likely dual prospect of steadily rising interest rates and decelerating
inflation, the U.S. became an attractive destination for foreign investment. The long
recession from 1981 to 1983 did not do much to abate the dollar’s rise. But the new
Reagan Administration’s fiscal policy would give a sharp upward push to the dollar
as the economic recovery commenced in 1983. Sizable tax cuts along with large
increases in defense spending generated large federal budget deficits. That federal
borrowing increased the demand for a shrinking pool of domestic saving and added
to the upward push on interest rates. Capital inflows increased and the dollar
climbed higher. It is also likely that once the dollar’s rise appeared relatively steady,
a strong round of speculative buying of dollar assets exacerbated the appreciation of
the exchange rate. The dollar peaked in 1985, about 50% above its level in 1979.
The next half of the decade would see depreciation of the dollar that was nearly
as large. What caused the change? One factor, difficult to isolate precisely, was a
turn in the speculative belief that the dollar would continue to rise. At this point, a
sufficient number of investors came to believe that the dollar was far above a
sustainable level and was now more likely to depreciate than appreciate. Of far more
importance to the process of depreciation, however, was a change in economic
policy. Investor expectations were given reinforcement by sizable currency
interventions by the U.S. and other major economies aimed at weakening the dollar.
Whatever the actual effectiveness at changing the exchange rate, these interventions
could be taken by international investors as a strong signal as to where the
government wanted the dollar to go and that more fundamental changes in
macroeconomic policy would support that desire. The Fed moved toward a more
stimulative monetary policy that pushed interest rates down. Fiscal policy also
slowly began to change toward a lower interest rate track, cutting the size of budget
deficits over the last half of the decade.
7(...continued)
Causes, Consequences, Cures, by Craig K. Elwell.
8The discussion in this section follows that found in Paul Krugman and Maurice Obstfeld,
International Economics: Theory and Policy (New York, NY: Harper-Collins, 1994), pp.
577-586.

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The depreciation of the dollar during 1986, 1987, and 1988 was precipitous,
falling to about 40% of its peak value in 1985 and below its 1979 level. In fact, the
concern among policy makers here and abroad was that the dollar would fall too far
and needed to be stabilized. Particularly, in 1986 and 1987 the United States and
other governments made active use of intervention policies in an attempt to halt the
dollar’s slide. How effective these policies were is unclear, but for this or other
reasons the dollar did enter a period of relative stability. This was interrupted in late
1987, when the Fed moved aggressively to counter the depressing effects of that
year’s stock market crash. Reserves were pumped into the financial system and
interest rates fell and with them so did the dollar in 1988. For the remainder of the
decade the dollar would not experience any sharp movements, remaining relatively
weak.
On balance, the decade showed us that strong dollar trends were not haphazard,
but were broadly predictable responses to changes in economic fundamentals that
influence the expected rate of return on dollar denominated assets. Moreover, in this
period those changes were largely induced by changes in macroeconomic policy.
However, the structural fact of the low U.S. saving rate clearly influenced the
economic events in this period.
The 1990s
The 1990s began in economic weakness. The pace of economic growth
decelerated sharply in 1990 and the economy fell into recession in 1991. In response
to the weakening economy, monetary policy turned to a more stimulative stance and
the federal budget deficit grew as economic weakness automatically increased
government spending and dampened tax receipts. Interest rates in the United States
fell. In contrast, economic activity abroad was moving relatively briskly. In this
environment, the demand for dollar assets ebbed and the dollar exchange rate fell,
depreciating about 15% between 1989 and 1992. In 1992 an economic recovery got
underway in the United States, but abroad economic conditions weakened
substantially. This change in relative economic performance was enough to induce
a moderate appreciation of the dollar, but it remained well below the values of the
1980s.
By mid-decade, however, the pace of economic growth in the U.S. accelerated
greatly. What lay behind this change to faster growth was a sharp increase in the
pace of investment spending by business and a marked acceleration in productivity
growth. The confluence of strong consumer demand, deregulation, trade
liberalization, and a rush to more fully integrate computers and information
technology into the production process propelled investment spending up at a record
pace. Expenditures on new plant and equipment went from about 13% of GDP in
1993 to average over 20% of GDP for the remainder of the decade. But even with the
move of the federal budget towards surplus, the flow of domestic saving could not
keep pace with investment and interest rates edged up. Couple this bourgeoning
saving - investment gap with a falling rate of inflation, and juxtapose the exuberant
economic conditions in the U.S. with very weak economies abroad, and the United
States became a very attractive destination for foreign investors. A quickly rising
foreign demand for dollar denominated assets would push the dollar steadily higher,

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rising over 30% from 1995 through 2001. With the strongly appreciating dollar, the
trade deficit increased to a record high.
This time the dollar’s sharp ascent was driven by the private sector. Economic
policy moved in conflicting directions, probably making its net impact on the dollar
a minor one. The government’s move toward budget surpluses certainly added to
national saving and likely muted the dollar’s rise, but this was unlikely the immediate
goal of this policy change. In contrast, the Fed implemented a steadily more
restrictive monetary policy that increased interest rates and this may have added to
the dollars upward momentum. Again, the Fed’s primary goal was to slow a very fast
moving economy and head off any re-acceleration of inflation. A rising dollar’s
pushing down of import prices was supportive of this anti-inflation goal and made
the Fed’s task easier, but the Fed was not the principal force behind that appreciation.

The 2000s
A rising dollar and the large inflow of net borrowing that pushes the currency
higher may not be inevitably sustainable. Borrower and lender alike may find good
reasons to reduce the size of the capital inflow. For the lender, rising risk and the
imperative of adequate portfolio diversification can prompt a diminished willingness
to acquire dollar denominated assets. For the borrower, a rising burden of debt
service (current and prospective ) may curb the desire to borrow. And, of course, if
the capital inflow is not checked by changes in private market decisions, it can be
changed by macroeconomic policy.
The depreciation of the dollar since 2002 reflects a weakening of the demand
for dollar denominated assets on the part of foreign investors. Recession in the
United States in 2001, a falling stock market, uncertainty about corporate accounting
practices, and a steady fall of most interest rates to levels not seen in over 30 years
(and falling significantly more than foreign interest rates) all point to a likely
deterioration of the attractiveness of the investment climate in this country. Add to
this the inevitable elevation of uncertainty due to the ongoing war on terrorism and
the war with Iraq, and some depreciation of the dollar is not surprising. It is also very
important to consider that given the magnitude of dollar assets that have
accumulated abroad, foreign investors may be ready to seek a greater degree of
diversity in their portfolios and evidence some movement away from dollar assets.
Instability and the Prospect of a Dollar Crash

When the dollar begins to fall, particularly after a sharp appreciation, concerns
are raised about whether a process of depreciation could soon devolve into an
outright crash, wreaking devastation on the wider economy. The critical issue is not
the dollar per se but the underlying macroeconomic forces that are propelling it.
Again the critical force in this regard is the flow of international capital into and out
of the U.S. economy. If foreign investors, for whatever reason, try to sharply reduce
their holdings of U.S. assets, the dollar will fall. The fear in some minds is that if
investors try to flee from dollar assets on a large scale the price of these assets will
be bid down and increase the effective interest rates. If the move out of dollars
becomes a stampede, the increase in interest rates might be very large — perhaps

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large enough to dampen domestic spending sufficiently to stall the already slow
moving economic recovery.
Such a disorderly adjustment is possible, but not highly probable. For one thing,
the tendency for interest rates to rise in this circumstance works to brake the process,
as higher yields assuage uneasy investors. But there is no guarantee that interest rates
still wouldn’t rise to a dangerously disruptive level. There are, however, other
reasons why a dollar crash is unlikely.
Of overriding importance is that, while not booming like the 1990s, the U.S.
economy remains fundamentally sound and an attractive place in which to invest.
While it is certainly possible that prudent foreign investors might slow their rate of
accumulation of U.S. assets, a “stampede” out of the U.S. capital market seems
remote. Reinforcing this conclusion, as noted above, is the circumstance that there
would seem to be a paucity of better investment alternatives around the globe. Most
other major economies have lower growth projections then does the United States.
Further, the prospect of a long series of large U.S. budget deficits in a growing
economy suggests that interest rates in the U.S. will soon be rising, and will make the
United States all the more an attractive destination for foreign capital. Finally, about
75% of foreign investment in the United States is long-term investment (e.g., direct
investment in plant and equipment, long maturity bonds, and stocks) which tends to
be far more stable than short-term investment flows because it is based on long-run
return and is therefore less sensitive to adverse short-run changes in economic
conditions.
Where Will the Dollar Go
Predicting the path of the dollar is always a problematic endeavor. Speculative
forces can exert strong near-term effects that may not be tied to more predictable
underlying fundamentals. But, even looking at fundamentals, the current period
seems particularly difficult to gauge because the dollar’s path will very likely depend
on the resolution of two strong but opposing forces: return and diversification.
The rate of return is a powerful incentive to the investor and there are several
reasons why the United States may remain for some time an attractive high return
destination. First, the U.S. economy is now in the midst of an economic expansion
with a credible prospect of achieving sustained annual growth in the 2.5% to 3.0%
range for the next few years. With this growth will come a steady rise in the rate of
investment spending. While it may be well short of the pace of the late 1990s,
increased investment spending will likely exert upward pressure on interest rates.
Second, this recovery is happening in an economy that will still have a very low
private sector saving rate, and thereby continue to have a heightened tendency
towards higher interest rates during periods of economic expansion. Third, the
Federal budget is now in deficit and those deficits are widely forecast to grow larger
in the period just ahead. Large and growing federal demands for loanable funds can
also be expected to exert significant upward pressure on interest rates. Fourth, for
the next year or more economic performance in most other major economies is very
likely to be weaker than in the United States, leading to a more pronounced
advantage in relative return for the United States. Further, if Europe and Japan are
trying to restart their slow moving economies, rising export sales are likely to figure

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importantly in their plans. A weakening dollar would mean foreign currencies are
appreciating, and dampening their exports. It is very likely these countries will take
steps to stop that appreciation, lowering their interest rates. Such steps would work
to strengthen the dollar. Taken together these factors will put substantial upward
pressure on the dollar.
Nevertheless, at some point the need for adequate diversification of assets in the
foreign investor’s portfolio will also be a strong motivating force and one that will
exert downward pressure on the dollar. Foreign holdings of U.S. assets are certainly
large. They are now rapidly approaching a value of $10 trillion, up over 60% in the
last five years. Of course, this would have to be compared to the overall size of
world-wide foreign investment holdings to venture a judgement as to whether the
foreign portfolio is saturated with dollar assets.
Our knowledge of foreign investor portfolios is limited, but a recent survey by
The Economist magazine shows that American assets make up 53% of the typical
foreign investors equity portfolio and 44% of the typical bond portfolio. As recently
as the mid-1990s, these percentages where only about 30%. It has also been
estimated that the average investor in recent years has allocated about 80% of his
increased wealth to dollar assets.9 If you also consider that historically, investors
have shown a marked preference for home assets, rarely letting the foreign share rise
above 30%, then one might reasonably project that the current holdings of U.S.
assets might be very close to the saturation point. Those portfolios have likely seen
a reduction of diversification over the last decade, and at some point, foreign
investors can be expected to move to increase diversification and become less willing
to accumulate U.S. assets at the current pace. But it is not clear that the saturation
point has been reached, particularly given the paucity of significantly superior
substitutes. Nevertheless, this factor could put substantial downward pressure on the
dollar.

Of course, it is not just a matter of what foreign private investors do. The
policies of foreign governments for the buying and selling of U.S. and foreign assets
can also influence the dollars path, and path preferred by government policy makers
could be contrary to the one dictated by private investor behavior. In the current
situation economic policy makers abroad may be uncomfortable with a greatly
weaker dollar because of its dampening effect on their exporting industries at a time
when they are struggling to maintain the pace of economic activity due to weak
domestic demand. As was noted at the beginning of this report, the dollar has fallen
far more against the euro then against the yen. This has occurred because the
Japanese government, hoping to prevent a major slowing of exports to the United
States, as been actively trying to slow the fall of the dollar relative to the yen by
purchasing dollar assets. If private investors are moving away from dollar assets on
a sizable scale, however, the asset market transactions of one or many governments
are unlikely to keep the dollar from falling, but they could certainly effect the timing
of that depreciation and it distribution across individual currencies.10
9The Economist, Sept. 18, 2003
10We are not talking here about macroeconomic policy, just government asset market actions
(continued...)

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CRS-15
The interplay of the two contending forces of return and diversification may
well push the dollar lower, stabilize it, or even push it higher. A common projection
is for the dollar to depreciate slowly, by enough to slow the rate of debt accumulation
to a slower and more sustainable pace, but not enough to stop the accumulation of
debt or lead to any near-term reduction of the trade deficit11
Economic Policy and the Ups and
Downs of the Dollar
We know that the macroeconomic tools of monetary and fiscal policy have the
potential to strongly influence the value of the dollar exchange rate. In practice,
however, these strong policy instruments only rarely take the dollar as their primary
concern. The goals of rapid and stable economic growth, high employment, and low
inflation are usually the principal targets of macroeconomic policy. The dollar will
likely be influenced by such policy actions, and its movement might well support
achieving broader macroeconomic goals; but a particular level for the exchange rate
is unlikely to be an explicit policy goal, and it would be misguided to describe such
indirect exchange rate effects as evidence of an explicit “strong” or “weak” dollar
policy. A major benefit of moving from fixed to floating exchange rates is that it
frees the monetary authority from having to move interest rates to maintain the
exchange rate at a fixed value, and allows it to focus monetary policy on domestic
stabilization. Discretionary fiscal policy, to the extent that it can be used, will exert
its effect on the exchange rate through the budget balance. Whether that balance is
a surplus or deficit will be driven by forces largely unconcerned with the exchange
rate.
If the dollar looked as if it were crashing and sharp increases of interest rates
are threatened, then a quick policy response would be called for and would likely be
forthcoming, most likely undertaken by the Fed. Such circumstances could place the
Fed in a difficult spot. Stabilizing the exchange rate would dictate raising interest
rates, but that would intensify the pressures faced by domestic interest-sensitive
sectors. Insulating domestic economic activity would dictate lowering interest rates,
but that would intensify the dollar’s depreciation. Most often, we can expect
domestic stabilization goals to take precedent. This task would be easier if fiscal
policy could also be used and easier still if other countries pursued complementary
adjustment policies. (Remember, if the dollar is falling, other currencies must be
rising, and that may not be desired by countries that are more dependent on exports.)
A crashing dollar could be a difficult policy problem. But, as discussed above, such
a crash seems to be a remote possibility.
Even if the dollar is unlikely to crash, some argue that the dollar is in need of
a sizable downward correction. The motive might be to give relief to domestic
producers of tradable goods or to stem the accumulation of foreign debt. How much
10(...continued)
aimed at the exchange rate.
11 See the projection by Global Insight, U.S. Economic Outlook, June, 2004.

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of a correction is open to debate, but it could certainly be well short of what is needed
to balance the trade deficit. As we have seen, the dollar’s path is largely dependent
on decisions in international capital markets, made by lenders and borrowers alike.
But policy can influence those decisions. One needs to be mindful, however, that
capital markets themselves are capable of inducing an orderly adjustment and that
such a market initiated adjustment may now be underway.
What is perhaps a more pertinent concern for economic policy are the factors
moving the dollar, specifically smaller net inflows of foreign capital. The direction
and magnitude of prospective movement of the dollar’s exchange value will be
substantially intertwined with the U.S. economy’s use of sizable inflows of foreign
financial capital to partially finance the economy’s domestic investment spending.
Healthy levels of investment spending undergird our long-term prosperity and we
probably should not be indifferent to how well this important activity is proceeding
Because investment spending will likely rise with economic recovery, and because
the level of domestic saving will likely continue to be smaller than what is needed
to finance that level of investment, the demand for foreign capital will also grow.
This will be a persistent force keeping the dollar relatively strong. “Relatively
strong” is a somewhat ambiguous term: what is being suggested is that the dollar in
this environment may hover well above the level consistent with balanced trade.
Whether this points to some further depreciation from recent highs or a renewal of
appreciation is difficult to judge.
For economic policy to prudently counter United States reliance on foreign
capital and push and hold the dollar at a far lower value, would most likely require
an increase in the rate of national saving. How we could achieve a larger flow of
domestic saving is problematic. Because the government’s most direct link to the
level of national saving — the state of balance of the federal budget — is widely
projected to be incurring deficits for the next several years, fiscal policy is assuming
a posture that tends to appreciate the dollar. The path of monetary policy is certainly
more flexible and the needs of a slowly recovering economy make it more likely that
the Fed will follow a generally stimulative path in the near-term. This would perhaps
be mildly supportive of depreciation of the dollar. But there is no strong reason to
expect monetary policy to exert such strong downward pressure on the dollar that it
would overcome even relatively moderate forces pushing to appreciate the dollar,
such as rising investment spending, larger budget deficits, and economic weakness
abroad.
Conclusion
A “weak” dollar is not necessarily bad and a “strong” dollar is not necessarily
good. An accurate evaluation will depend on what has made the dollar weak or
strong. The exchange rate is most often a symptom of movements of capital between
countries. It is these flows, and the forces behind them, that are likely to shape our
final opinion about what is good or bad economic performance.
A strong dollar that is the result of large capital inflows used to support budget
deficits and consumption, as in the 1980s, may be viewed differently than a strong

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dollar that is the result of capital inflows that finance a higher level of investment
spending. The latter, because it will likely lead to a smaller decrement to our future
living standard, seems superior. Similarly, a dollar that weakens in response to a
shift to a higher level of domestic saving may be viewed differently than a weakening
that is the result of investors moving away from a poorly run economy with few good
investment opportunities. The former, because it will mean that more of the benefit
of future growth will accrue to U.S. citizens, seems superior.

The recent weakening of the dollar is most likely a prudent response of investors
to recent events in the U.S. economy, many of them likely transitory. And a slowing
of U.S. debt accumulation may prove to be a positive development , particularly if
it is caused by an increase in the rate of domestic saving. Yet how much weakening
will occur is problematic. Under the most plausible scenario the U.S. economy will
continue to use a sizable inflow of foreign capital to help finance domestic
investment and will grow faster than other major economies. This would suggest
that the dollar may not fall all that far.

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