The Depreciating Dollar: Economic Effects
and Policy Response
Craig K. Elwell
Specialist in Macroeconomic Policy
April 15, 2011
Congressional Research Service
7-5700
www.crs.gov
RL34582
CRS Report for Congress
P
repared for Members and Committees of Congress
The Depreciating Dollar: Economic Effects and Policy Response
Summary
A trend depreciation of the dollar since 2002 raises concern among some in Congress and the
public that the dollar’s decline is a symptom of broader economic problems, such as a weak
economic recovery, rising public debt, and a diminished standing in the global economy.
However, a falling currency is not always a problem, but possibly an element of economic
adjustments that are, on balance, beneficial to the economy.
A depreciating currency could affect several aspects of U.S. economic performance. Possible
effects include increased net exports, decreased international purchasing power, rising commodity
prices, and upward pressure on interest rates; if the trend is sustained, reduction of external debt,
possible undermining of the dollar’s reserve currency status, and an elevated risk of a dollar
crisis.
The exchange rate is not a variable that is easily addressed by changes in legislative policy.
Nevertheless, although usually not the primary target, the dollar’s international value can be
affected by decisions made on policy issues facing the 112th Congress, including decisions related
to generating jobs, raising the debt limit, reducing the budget deficit, and stabilizing the growth of
the federal government’s long-term debt. Also monetary policy actions by the Federal Reserve,
over which Congress has oversight responsibilities, can affect the dollar.
The exchange rate of the dollar is largely determined by the market—the supply and demand for
dollars in global foreign exchange markets. In most circumstances, however, international asset-
market transactions will tend to be dominant, with the size and strength of inflows and outflows
of capital ultimately determining whether the exchange rate appreciates or depreciates.
A variety of factors can influence the size and direction of cross-border asset flows. Of principal
importance are the likely rate of return on the asset, investor expectations about a currency’s
future path, the size and liquidity of the country’s asset markets, the need for currency
diversification in international investors’ portfolios, changes in the official holdings of foreign
exchange reserves by central banks, and the need for and location of investment safe havens. All
of these factors could themselves be influenced by economic policy choices.
To give Congress the economic context in which to view the dollar’s recent and prospective
movement, this report analyzes the evolution of the exchange rate since its peak in 2002. It
examines several factors that are likely to influence the dollar’s medium-term path, what effects a
depreciating dollar could have on the economy, and how alternative policy measures that could be
taken by the Federal Reserve, the Treasury, and the 112th Congress might influence the dollar’s
path.
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Contents
Introduction ................................................................................................................................ 1
Broad Economic Forces That Affect the Dollar............................................................................ 2
Determinants of the Size and Direction of Cross-Border Asset Flows .......................................... 3
Interest Rate Differentials Between the United States and Other Economies .......................... 3
Investors’ Expectations About the Future Path of the Dollar .................................................. 4
Investors Diversifying Their Portfolio of Assets .................................................................... 5
Other Factors That Influence the International Demand for Dollar Assets .............................. 5
The Size and Liquidity of U.S. Asset Markets ................................................................. 6
U.S. Asset Markets are Often Seen as “Safe Havens†...................................................... 6
The Dollar is the Principal Global “Reserve Currency†................................................... 7
How Will These Determinants Interact to Affect the Dollar?.................................................. 8
Likely Effects of Dollar Depreciation .......................................................................................... 9
A Smaller Trade Deficit......................................................................................................... 9
U.S. International Purchasing Power Decreases................................................................... 10
U.S. Net External Debt Is Reduced...................................................................................... 11
World Commodity Prices (in Dollars) Tend to Increase ....................................................... 12
Other Possible Effects of Dollar Depreciation............................................................................ 13
U.S. Interest Rates Could Increase....................................................................................... 13
Dollar’s Reserve Currency Role Could Be Reduced ............................................................ 13
Risk of a Dollar Crisis Could Be Increased.......................................................................... 15
Policies That Could Influence the Dollar ................................................................................... 16
Does the United States Have a Dollar Policy?...................................................................... 16
Policies to Influence the Demand for U.S. Assets ................................................................ 17
Direct Intervention in the Foreign Exchange Market...................................................... 17
Monetary Policy............................................................................................................ 18
Fiscal Policy and Federal Debt ...................................................................................... 18
Policies to Increase the Demand for U.S. Exports................................................................ 19
Lower Foreign Trade Barriers ....................................................................................... 19
Support for Development of New Products ................................................................... 19
Indirect Government Influence on the Dollar....................................................................... 19
Global Imbalances, the Dollar, and Economic Policy................................................................. 20
Figures
Figure 1. Trade-Weighted Exchange Rate of Dollar ..................................................................... 2
Contacts
Author Contact Information ...................................................................................................... 21
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The Depreciating Dollar: Economic Effects and Policy Response
Introduction
From a peak in early 2002 to mid-2008, the (inflation adjusted) trade-weighted dollar exchange
rate, for the most part, steadily depreciated, falling a total of about 26% (see Figure 1). The
dollar’s fall over this six-year period was moderately paced at about 3% to 4% annually. For the
next nine months, as the wider economy was reeling from the effects of the financial crisis and
recession, the dollar sharply appreciated, increasing more than 11% on a trade-weighted basis.1
For reasons that will be discussed later in the report, this appreciation was a market response to
the great uncertainty associated with those economic troubles. As economic conditions began to
stabilize in mid-2009, the dollar began to depreciate again and has fallen about 10% through the
end of 2010.
The dollar’s fall from 2002 through early 2008 as well as the recent depreciation has not been
uniform against individual currencies, however. For example, in the earlier period, it fell 45%
against the euro, 24% against the yen, 18% against the yuan, and 17% against the Mexican peso.
In the period since the trough of the business cycle in mid-2009, the dollar fell 13% against the
euro, 11% against the yen, less than 3% against the yuan (all of which occurred recently), and 8%
against the peso.
These differing amounts of depreciation are partly a reflection of the countries’ willingness to let
their currencies fluctuate against the dollar. The euro is free floating, the yen has been moderately
managed (mostly before 2005 but more deliberately since September 2010), and the yuan is
actively managed (its value rigidly fixed to the dollar before 2005 and from mid-2008 until mid-
2010; since then allowed to rise moderately against the dollar).2 But the pattern also reflects
significant structural asymmetries in flows of global assets and global goods, as well as
differences in business cycles, inflation rates, shocks affecting the different economies, and an
unwinding of imbalances that were present in 2002.3
The weakening of the dollar raises concern in Congress and among the public that the dollar’s
decline is a symptom of broader economic problems, such as a weak economic recovery, rising
public debt, and a diminished standing in the global economy. Have recent policy actions such as
quantitative easing by the Federal Reserve (Fed) and fiscal stimulus passed by the 111th Congress
had an effect on the dollar? How might failure by the 112th Congress to raise the federal debt
ceiling or address the country’s long-term government debt problem affect the exchange rate? Is
there a positive side to dollar depreciation?
1 The 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. The real or inflation-adjusted exchange rate is the relevant measure for
gauging effects on exports and imports. A trade-weighted exchange rate index is a composite of a selected group of
currencies, each dollar’s value weighed by the share of the associated country’s exports or imports in U.S. trade. The
broad index cited here is constructed and maintained by the Federal Reserve. The broad index includes the currencies
of 26 countries comprising 90% of U.S. trade and, therefore, the broad index is a good measure of changes in the
competitiveness of U.S. goods on world markets.
2 See CRS Report RL33577, U.S. International Trade: Trends and Forecasts, by Dick K. Nanto and J. Michael
Donnelly for more data and charts on exchange rates.
3 Data on bilateral exchange rates are available at Board of Governors of the Federal Reserve System, Federal Reserve
Statistical Release H.10, http://www.federalreserve.gov/releases/h10/hist/.
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Figure 1. Trade-Weighted Exchange Rate of Dollar
140
130
120
110
100
Index
90
80
70
60
50
1990-02
1995-02
2000-02
2005-02
2010-02
Source: Board of Governors of the Federal Reserve System.
Economic theory suggests that the dollar’s path can be influenced by a variety of factors that
could confer to the United States both benefits and costs, and in some circumstances a
depreciating currency can be, on balance, beneficial. This report examines the several factors that
are likely to influence the dollar’s medium-term path; why further depreciation could occur; what
effects a depreciating dollar could have on the economy, including the pace of economic
recovery; and how alternative policy measures might influence the dollar’s path.
Broad Economic Forces That Affect the Dollar
Since the break-up of the Bretton Woods international monetary system in 1973, the exchange
rate of the dollar has been largely determined by the market—the supply and demand for dollars
in global foreign exchange markets. Dollars are demanded by foreigners to buy dollar
denominated goods and assets. (Assets include bank accounts, stocks, bonds, and real property.)
Dollars are supplied to the foreign exchange markets by Americans exchanging them for foreign
currencies typically needed to buy foreign goods and assets.
Since the mid-1990s, the United States has had a growing trade deficit in goods transactions,
generating a net increase in the supply of dollars on the foreign exchange markets, thereby
exerting downward pressure on the dollar’s exchange rate. At the same time, the United States has
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had an equal-sized surplus in asset transactions, reflecting a net increase in the demand for dollars
on the foreign exchange market, thereby exerting upward pressure on the dollar’s exchange rate. 4
In most circumstances, however, there is a strong expectation that asset-market transactions will
tend to be dominant and ultimately dictate the exchange rate’s direction of movement. This
dominance is the result of gross asset-market transactions occurring on a scale and at a speed that
greatly exceeds what occurs with goods-market transactions. Electronic exchange makes most
asset transfers nearly instantaneous and, in most years, U.S.-international asset transactions were
two to three times as large as what would be needed to simply finance that year’s trade deficit.
In 2007, near the peak of the last economic expansion, the U.S. capital account recorded $1.5
trillion in purchases of foreign assets by U.S. residents (representing a capital outflow) and $2.1
trillion in purchases of U.S. assets by foreign residents (representing a capital inflow). So while
the United States could have financed the $702 billion trade deficit in goods and services in 2007
simply by a $702 billion sale of assets to foreigners, U.S. and foreign investors engaged in a
much larger volume of pure asset trading.5
Determinants of the Size and Direction of Cross-
Border Asset Flows
Economic theory suggests that several economic factors could influence the direction of cross-
border asset flows.
Interest Rate Differentials Between the United States and
Other Economies
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. Therefore, differences in the
level of interest rates between economies are, other things equal, likely to stimulate international
capital flows from countries with relatively low interest rates to countries with relatively high
interest rates, as investors seek the highest rate of return for any given level of risk. When
inflation rates among economies are similar, the average level of nominal interest rates can be
used as a fairly reliable first approximation of the rate of return on an asset in a particular
currency.
4 The current account is a tally of international purchases (imports) and sales (exports), and the current account balance
measures the country’s net exports of goods and services. The capital account is a tally of international purchases and
sales of dollar denominated assets, and the capital account balance measures the country’s net foreign investment. If the
capital account is in surplus, foreigners are investing more in the United States then Americans are investing abroad,
leading to a net inflow of capital. Because every purchase of a foreign good or asset requires the payment of a domestic
good or asset, net flows in the current account and the capital account will be equal and offsetting. Therefore a current
account deficit must be matched by an equal capital account surplus, and a current account surplus by a capital account
deficit. The exchange rate adjusts to make this so.
5 See U.S. Department of Commerce, Bureau of Economic Analysis, U.S. International Economic Accounts, 2007,
Table 1, http://www.bea.gov/international/bp_web/list.cfm?anon=71®istered=0.
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Rates of return on dollar assets can be influenced by the general performance of the economy as
gauged by its ability to sustain a high rate of economic growth and a low rate of inflation.
Another potential influence on expected rate of return is the Fed‘s conduct of monetary policy as
it periodically moves interest rates up or down to stabilize the economy. In addition, whether the
United States business cycle is synchronous or asynchronous with that of other economies will
influence the relative level of interest rates between it and other economies. In general, these
relatively short-term interest rate fluctuations will tend to either attract or deter foreign capital
flows, particularly in relatively liquid assets.
The rate of return advantage in the U.S. economy may be greater than the spread between market
interest rates would suggest, however. A study by the International Monetary Fund (IMF) that
focused on return to debt and equity capital for publicly traded companies in the large industrial
economies and the developing economies for the decade 1994-2003 found the rate of return in the
United States to have been about 8.6% as compared with a G-76 average of about 2.4% and an
emerging market average of about minus 4.7%.7
Currently, the combination of substantial economic slack and highly stimulative monetary policy
in the United States and other advanced economies has pushed down short-term and long-term
interest rates to historically low levels and left virtually no sizable interest rate advantage of
dollar assets over assets in the currencies of other G-7 economies. For example, the yields on 10-
year government bonds in Germany, Canada, the United Kingdom, and the United States during
2010 have been within a narrow band of 3.0% to 3.5%. Japan, however, has been an outlier
among advanced economies, with the yield on 10-year government bonds hovering slightly above
1% over this period. In contrast, many emerging economies are showing much stronger economic
performance and asset yields are likely to be substantially above those in the United States and
other advanced economies, which could entice many investors to move capital from the advanced
economies to the emerging economies. This would exert downward pressure on the currencies of
the advanced economies, including the dollar.
Investors’ Expectations About the Future Path of the Dollar
Whether a currency’s exchange rate will rise or fall in the future can figure prominently in some
investors’ calculation of what will actually be earned from an investment denominated in another
currency. If, for example, the dollar depreciated on average 4% annually for the next several
years, then the 2% to 4% average nominal interest rates currently attached to low-risk medium to
long-term U.S. securities would offer the foreign investor an expected return of approximately
zero or less. (If the expected currency depreciation were greater, the investor would expect to
incur a capital loss.) In general, expected dollar depreciation lowers the expected return and
reduces the attractiveness of dollar assets to the foreign investor. On the other hand, if the
exchange rate is expected to appreciate, the expected gain would be greater than the nominal
interest rate attached to the security, making that asset more attractive. Investor expectations will,
therefore, tend to act as an accelerant, adding momentum to the exchange rates movement,
whether up or down. At the extremes this could be destabilizing, generating sizable over-
valuations or under-valuations of a currency.
6 The G-7 refers to the periodic Group of Seven finance ministers and central bank governors conference. The seven
countries represented are Canada, Japan, France, Germany, Italy, the United Kingdom, and the United States.
7 International Monetary Fund, World Economic Outlook, Global Imbalances: In a Saving and Investment Perspective,
September 2005, pp. 100-104.
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The dollar’s long and generally orderly depreciation between 2002 and 2008 suggests investor
expectations about the currency’s path did not act as a destabilizing factor. Nevertheless, the
prospect of a secular depreciation likely reduced the attractiveness of dollar denominated assets to
foreign investors at that time, and if the current depreciation of the dollar is seen as a resumption
of that secular depreciation the attractiveness of dollar assets could also continue to be eroded.
Investors Diversifying Their Portfolio of Assets
For any given interest rate differential and level of the exchange rate, international investors are
likely to have a desired balance of assets in their portfolios, allocated not only among types of
assets but also by the currency the assets are denominated in. As the stocks they hold of particular
assets change over time, investors may see the need to rebalance their portfolios, shifting asset
flows away from or toward assets denominated in a particular currency.
Such rebalancing can cause exchange rates for the denominating currency to increase or decrease
as well.8 For example, even if dollar assets offer a relatively high return, at some point foreign
investors, considering both risk and reward, could decide that their portfolio’s share of dollar-
denominated assets is large enough. To mitigate exposure to currency risk in their portfolios,
investors could slow or halt their purchase of dollar assets and increase their holdings of non-
dollar assets. Such a diversification, other things equal, would tend to depreciate the dollar.
How much pure diversification from dollar assets is likely to happen over the near-term is
difficult to determine. Nevertheless, with nearly $10 trillion in U.S. securities estimated to be in
foreign investor portfolios, diversification toward other currencies could arguably be a factor of
growing importance.9 However, over the near-term, the general economic fragility of other
advanced economies could mean there will be a lack of strong alternatives to dollar assets,
tending to limit international investors’ willingness to diversify into assets denominated in other
currencies. On the other hand, the recent strong growth of many emerging economies could make
them an increasingly attractive alternative destination for international capital flows.
Other Factors That Influence the International Demand for
Dollar Assets
Beyond the standard determinants of risk and reward that are likely to have a strong near-term
influence on the relative attractiveness of dollar-denominated assets, the United States has some
added advantages that are thought to generate a sustained underlying demand for dollar assets.
8 Prudent investment practice counsels that the investor’s portfolio of asset holdings have not only an appropriate
degree of diversification across asset types, but also diversification across the currencies in which the assets are
denominated. Moving from a relatively undiversified investment portfolio to a more diversified one spreads risk,
including exchange rate risk, across a wider spectrum of assets and helps avoid over- exposure to any one asset.
9 U.S. Department of the Treasury, Report on Foreign Portfolio Holdings of U.S. Securities, Table 1, May 13, 2010,
http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/shl2009r.pdf.
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The Size and Liquidity of U.S. Asset Markets
Large asset markets, such as those in the United States, offer a great variety of asset types and a
high degree of liquidity. This means that these asset markets are able to handle large inflows and
outflows of funds with only a small impact on the price of the asset. Recent IMF estimates of the
relative size of the asset markets in the advanced economies show that in 2009 the U.S. bond
market had a total value of nearly $32 trillion (with government bonds accounting for about $9.5
trillion of that), whereas the United Kingdom, Germany, and Japan had much smaller bond
markets with a total value of about $4.7 trillion, $5.7 trillion, and $12 trillion, respectively. In
addition, the U.S. stock market has an estimated capitalized value of nearly $15 trillion, whereas
the United Kingdom, Germany, and Japan’s equity markets were estimated to have capitalized
values of about $2.8 trillion, $1.3 trillion, and $3.4 trillion, respectively.10
A good example of a large highly liquid asset market is that for U.S. Treasury securities, which
has been particularly attractive to foreign investors in recent years. Federal Reserve data show
that for the week ending February 23, 2011, the U.S. government securities markets had a daily
turnover of about $680 billion. Additional evidence of the high liquidity of U.S. government
securities market is its typically small bid-ask spreads. On relatively short-term Treasury
securities, the spread is usually a few tenths of a cent per $100 dollar face value of the security.11
In recent years, the high liquidity of dollar assets has been an attractive feature for foreign central
banks, which have been rapidly increasing their holdings of foreign exchange reserves, a
substantial portion of which are thought to be dollar assets. The same is true for petroleum
exporting countries, which have in recent years needed to store tens of billions of dollars but also
to have ready access to those funds with minimal market disruption.
The degree to which market size influences inflows of foreign capital is hard to determine.
However, the persistence of large capital inflows to the United States despite already large foreign
holdings of dollar assets offering modest interest differentials and the disproportionate share of
essentially no-risk and high-liquidity U.S. Treasury securities in foreign holdings suggest that the
magnitude of flows attributable to the liquidity advantage of U.S. asset markets is probably
substantial. Failure of the U.S. government, however, to address its long-term government debt
problem could raise concerns about default risk and quickly degrade the attractiveness of
Treasury securities to foreign investors, and tend to weaken the dollar.
U.S. Asset Markets are Often Seen as “Safe Havensâ€
Many 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. 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 safe-haven-related demand for dollar assets
was particularly evident in 2008 (see Figure 1), when uncertainty about global economic and
financial conditions caused a substantial “flight to quality†by foreign investors that sharply
appreciated the dollar. As global markets stabilized in 2009, the safe haven demand abated
10 IMF, Global Financial Stability Report, October 2010, Statistical Appendix, Table 3, http://www.imf.org/External/
Pubs/FT/GFSR/2010/02/pdf/statappx.pdf.
11 Federal Reserve Bank of New York, Primary Dealer Transactions in U.S. Government Securities, February 23,
2011, http://www.newyorkfed.org/markets/statistics/deal.pdf.
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somewhat, contributing to the depreciation of the dollar that occurred in the second half of 2009
and during 2010.
The ongoing size of the safe-haven demand for dollar assets is not easy to determine, but the
disproportionate share in foreign holdings of U.S. Treasury securities, which markets still
consider to be essentially without default risk, suggests that the magnitude of safe-haven
motivated flows is probably substantial, capable of periodically exerting sizable upward pressure
on the dollar. Again, perceptions of how “safe†dollar assets are likely to be is influenced by how
the 112th Congress addresses the federal government’s long term debt problem.12
The Dollar is the Principal Global “Reserve Currencyâ€
A reserve currency is a currency held in sizable quantities by foreign governments and central
banks as part of their holdings of foreign exchange. Unlike private investors, central banks hold
foreign exchange reserves primarily for reasons other than expected rate of return. These so-
called official holdings generally serve two objectives. First, the accumulation of a reserve of
foreign exchange denominated in readily exchangeable currencies, such as the dollar, provides a
safeguard against currency crises arising out of often volatile private capital flows. This is most
often a device used by developing economies that periodically need to finance short-run balance
of payments deficits and cannot fully depend on international capital markets for such finance. In
the wake of the Asian financial crisis of 1997-1998, many emerging economies built up large
stocks of foreign exchange reserves, a large share of which were denominated in dollars.
Second, official purchases are used to counter the impact of capital flows that would otherwise
lead to unwanted changes in the countries’ exchange rates. This is a practice used by China and
many east Asian economies that buy and sell dollar assets to influence their exchange rates
relative to the dollar in order to maintain the price attractiveness of their exports.
Globally, central bank holdings of reserve currency assets have risen sharply in recent years. The
IMF reports that from 2002 through the third quarter of 2010, worldwide official holdings of
foreign exchange reserves increased from about $2 trillion to nearly $9 trillion. Given the dollar’s
status as the dominant international reserve currency, a large portion of the accumulation was of
dollar-denominated assets. IMF data indicate that of the $5 trillion of official holdings of which
currency composition is known, nearly $3 trillion (or 60%) are in dollar assets. 13 In addition, the
U.S. Treasury reports that through January 2011, $3.2 trillion (or 67%) of the $4.5 trillion
marketable Treasury securities held by foreigners was being held as foreign official reserves.14
(The total amount of Treasury securities held by the public, foreign and domestic, through
January 2011 was about $9.5 trillion.)15
12 On the demand for safe assets see Ben S. Bernanke, ‘International capital flows and the returns to safe assets in the
United States 2003-2007, Financial Stability Review, Banque de France, no. 15, February 2011, http://www.banque-
france.fr/gb/publications/telechar/rsf/2011/etude02_rsf_1102.pdf.
13 In contrast, the United States in this time period held foreign exchange reserves of less than $200 billion on average,
with annual increments of only $1 billion to $10 billion. See IMF, Currency Composition of Official Foreign Exchange
Reserves, December, 2010, http://www.imf.org/external/np/sta/cofer/eng/cofer.pdf.
14 U.S. Department of the Treasury, Treasury International Capital System (TIC), Major Foreign Holders of Treasury
Securities, http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt.
15 U.S. Department of the Treasury, Treasury Direct, Dept to the Penny, http://www.treasury.gov/resource-center/data-
chart-center/tic/Documents/mfh.txt.
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In 2010, China was the world’s largest holder of foreign exchange reserves, with holdings valued
at more than $2.5 trillion,16 an increase of about $2 trillion since 2002. The exact currency
composition of China’s foreign exchange reserves is not made public, but the dollar share is
thought to be large because that accumulation is largely the consequence of China’s buying dollar
assets to stabilize the value of its currency relative to the dollar.
Japan is the second largest holder of foreign exchange reserves, with holdings valued at about $1
trillion; however, these reserves were largely accumulated prior to 2005.17 Japan has not in recent
years actively tried to influence the value of its currency; nevertheless, dollar assets are thought to
be a large share of its reserves. But on March 17, 2011, Japan announced that it would, in concert
with other Group of 7 (G-7) nations, intervene in currency markets to stabilize the value of the
yen.
The Japanese currency had spiked following the earthquake on March 11, 2011, threatening to
stall Japan’s exports and deliver another blow to an economy already staggered by that disaster.
Japanese officials believed that the yen’s sudden strength was being driven by speculation that
Japan’s firms and financial institutions would soon be bringing back a large portion of their
overseas investments to fund Japan’s reconstruction. The intervention entailed the selling of yen-
denominated assets, tending to push down its value relative to other G-7 currencies, such as the
dollar. This was the first joint currency intervention by the G-7 countries in over a decade.18
Since the third quarter of 2009, however, the total accumulation of dollar assets by foreign central
banks has slowed moderately. Of the $1.1 trillion increase in global foreign exchange reserves for
the four quarters ending in the third quarter 2010, dollar holdings increased $333 billion, at about
half the rate of earlier increases.19
How Will These Determinants Interact to Affect the Dollar?
At any point in time, all of the above factors will exert some amount of upward or downward
pressure on the value of the dollar, often pushing in opposite directions, making it difficult to
disentangle them from their net effect on the dollar. It is difficult to explain with clarity or predict
with precision the dollar’s near-term path (i.e., several weeks to several months ahead). However,
it is possible to assess the general disposition of the forces (as discussed above) likely to influence
the dollar in 2011 and 2012.
The following factors point to near-term depreciation of the dollar:
• Low interest rates and slow economic growth in the United States, particularly in
comparison to emerging economies, likely lowers the relative expected rate of
return on dollar assets.
16 Statistics on Chinese international reserves are from Chinability, a nonprofit provider of Chinese economic and
business data, http://www.chinability.com/Reserves.htm.
17 Japan, Ministry of Finance, February 28, 2011, http://www.mof.go.jp/english/e1c006.htm.
18 Binyamin Appelbaum, “Goup of 7 to Intervene to Stabilize the Yen’s Value,†New York Times March 17, 2011,
http://www.nytimes.com/2011/03/18/business/global/18group.html.
19 IMF, Currency Composition of Official Reserves, December 30, 2010, http://www.imf.org/external/np/sta/cofer/eng/
cofer.pdf.
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• International holdings of dollar assets is high and prudent portfolio management
could lead to diversification toward other currencies.
• A substantial trade deficit in goods continues to exert downward pressure on the
dollar.
• If concerns about euro area sovereign debt problems abate, this will likely reduce
recent safe-haven-motivated inflows for dollar assets.
• A growing inflation problem could induce China to slow accumulation of dollar
reserves and let its currency rise relative to the dollar.
Likely Effects of Dollar Depreciation
Standard economic analysis suggests that a sustained depreciation in the value of the dollar in
international exchange has several likely effects, positive and negative, on the U.S. economy.
A Smaller Trade Deficit
The exchange rate determines the relative price of domestic goods and foreign goods, thus it can
influence the value and volume of exports sold and imports bought and, in turn, influence the
trade balance. Because a depreciating dollar improves the price competitiveness of U.S. exports
in foreign markets and deteriorates the price competitiveness of foreign goods in U.S. markets, it
will tend to reduce the U.S. trade deficit.20
A smaller trade deficit is likely to have two favorable effects on the U.S. economy: first, it will
subtract less from demand in the economy, providing a boost to employment; and second, it will
slow the growth of U.S. foreign indebtedness. In an economy that still has substantial economic
slack, stronger U.S. exports increase domestic economic activity and boost employment; weaker
imports represent a rechanneling of domestic spending away from foreign goods and toward
domestic goods, which also increases domestic economic activity and boosts employment.
Because the U.S. trade deficit is financed by borrowing from the rest of the world (as evidenced
by an equal sized net inflow of foreign capital), a smaller trade deficit will slow the rise of an
already substantial net foreign indebtedness and could temper the associated concern about a
rising external debt service burden.
The period 1985-1991 was the last time a substantial dollar depreciation and trade deficit
adjustment occurred.. At that time, the dollar fell a cumulative 40% from a historically high level.
In response, the trade deficit started to narrow within two years of the initial depreciation, falling
from 3.5% of GDP to near balance by 1991.
20 This effect is likely to be evident first on real trade flows (the volume of exports and imports) and more slowly on
nominal trade flows (the current dollar value of exports and imports). This differential effect on real and nominal flows
occurs because the higher relative price of imports has two impacts. On the one hand, domestic consumers buy a
reduced volume of foreign goods, while on the other hand, each unit of the foreign goods is valued higher in terms of
dollars. Initially, the volume effect can be dominated by the value effect, causing the nominal trade balance to not fall
or perhaps even rising for a period in response to a depreciating exchange rate. Ultimately, the volume effect could
come to dominate the value effect and the nominal trade deficit would also begin to fall.
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For the period 2002-2007, despite a large depreciation of the dollar, the adjustment process has
been much slower, with the trade deficit only tipping down modestly in 2007. However, the
depreciation of the dollar was having an impact. Economic research suggests that in the United
States, depreciation is likely to have a quicker and stronger impact on exports than on imports.21
This seems to have occurred. Real (non-petroleum) exports began to accelerate in 2003 (the first
full year of dollar depreciation) and would continue to grow at a nearly 10% annual rate through
2006 (the year the trade deficit peaked).22
The slow effect of the depreciating dollar on the trade balance was the result of import volumes
continuing to grow. Again, economic research suggests that U.S. imports have a relatively muted
response to exchange rate changes, with a dollar depreciation more likely to slow their growth
rather than cause them to decrease. However, in this period several other factors worked to
increase imports above what otherwise might be expected and caused a particularly slow response
of the trade deficit to the depreciation of the dollar. First, the rapid shift in trade in recent years
toward low-cost emerging economies has tended to erode U.S. price competiveness and offset, in
part, the competiveness improving effect of the depreciating dollar. Second, up to 2006 the U.S.
economy was growing faster than most other advanced economies, tending to boost U.S. imports.
Third, oil prices rose to historic highs, increasing the trade deficits of oil-importing countries,
such as the United States. (Because the international price of oil is denominated in dollars, dollar
depreciation does not directly affect oil’s price in the U.S. market. However, some argue it
directly contributes to commodity price inflation. This possible relationship is discussed in the
“World Commodity Prices (in Dollars) Tend to Increase†section below.)
The U.S. trade deficit in 2010 increased to $470 billion.23 The deficit’s increase from 2009’s
recession induced low of $378 billion was to be expected in a recovering economy, as rising
economic activity at home and abroad increased goods and asset flows to more normal levels. In
particular, the rebuilding of inventories by U.S. businesses, typical in the early stages of
economic recovery, drew in a sizable volume of imports. But that process is transitory and likely
already substantially completed. With the dollar already at a relatively competitive level and with
strong growth occurring in most emerging economies, there may be strong demand for U.S.
exports. Barring a major spike in oil prices or an unlikely surge in spending by U.S. consumers,
the trade deficit could stabilize for the near-term at about $500 billion. Any further dollar
depreciation will give added momentum to exports and will raise the prospect that the trade
deficit could fall over the next few years and help to boost the rate of economic growth.
U.S. International Purchasing Power Decreases
The rising price of imports relative to exports caused by a depreciation of the dollar reduces the
purchasing power of U.S. consumers and businesses that purchase imports. To judge the
combined effect of export and import price changes on U.S. international purchasing power,
economists use the change in the ratio of export prices to import prices or what is called the terms
21 International Monetary Fund, World Economic Outlook September 2007, Chapter 3, “Exchange
Rates and the Adjustment of External Imbalances.â€
22 U.S. Census Bureau, U.S. International Trade Data, http://www.census.gov/foreign-trade/statistics/historical/
realpetr.pdf.
23 Bureau of Economic Analysis, U.S. International Transactions Account, Table 1, line 77, http://www.bea.gov/
international/bp_web/simple.cfm?anon=71&table_id=1&area_id=3.
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of trade. For the 26% dollar depreciation that began in early 2002 and ended in mid- 2008, the
U.S. terms of trade for the same period decreased by approximately 13%.24
A 13% decrease in the terms of trade is substantially less than the depreciation of the dollar,
which reflects changes in factors in addition to the exchange rate. One factor of particular
significance is the effect of changes in producer profit margins. To preserve market share in the
U.S. market, importers have shown a tendency to not completely pass through exchange rate
depreciations to the dollar price of their products, absorbing a portion of the exchange rate change
through slimmer profit margins. This practice substantially mutes the currency depreciation’s
negative effect on U.S. purchasing power. Also likely muting the impact of a fall in the terms of
trade on total purchasing power is the relatively small importance of imports in U.S. gross
domestic product (GDP), which only total about 16%.
The dollar value of the loss of purchasing power caused by the dollar’s depreciation from 2002 to
2008 can be estimated by comparing the growth of real GDP to the growth of real command-basis
gross national product (GNP). Command-basis GNP measures the goods and services produced
by the U.S. economy in terms of their international purchasing power. In particular, it adjusts the
value of real exports to reflect changes in their international purchasing power due to changes in
the U.S. terms of trade. Thus, when the terms of trade ratio decreases because of dollar
depreciation, real command-basis GNP falls relative to the normally calculated real GDP.25 From
early 2002 through mid-2008, real GDP increased a cumulative $1.9 trillion as compared with
command-basis real GDP increasing about $1.6 trillion. The difference of about $300 billion is
the estimated loss of international purchasing power due to the dollar’s 26% depreciation for that
time period.
U.S. Net External Debt Is Reduced
A depreciating dollar tends to improve the U.S. net debt position. This improvement is caused by
favorable valuation effects on U.S. foreign assets. These occur because U.S. foreign liabilities are
largely denominated in dollars, but U.S. foreign assets are largely denominated in foreign
currencies. Therefore, a real depreciation of the dollar increases the value of U.S. external assets
and largely does not increase the value of U.S. external liabilities. This asymmetry in the currency
composition of U.S. external assets and liabilities means that a dollar depreciation tends to reduce
U.S. net external debt.26
Exchange rate induced valuation effects are substantial because they apply to the entire stock of
U.S. foreign assets, valued at about $18.4 trillion in 2009. The large scale of U.S. foreign assets
means that valuation changes can offset a sizable portion of the current account deficit’s annual
addition to the existing stock of external debt. For example, in 2006, the current account deficit
reached a record $81l.4 billion. As this was financed by foreign borrowing, it made a like-sized
contribution to U.S. external debt. However, the total value of net external debt in 2006 increased
only about $300 billion because valuation changes caused the value of the stock of U.S. foreign
24 Bureau of Economic Analysis, National Economic Accounts, Table 1.8.6, http://www.bea.gov/national/nipaweb/
SelectTable.asp?Selected=N.
25 Ibid.
26 Most countries are not able to borrow in their own currency, so a fall of their exchange rate will tend to increase their
net external debt. This was a problem that plagued the economies caught in the Asian financial crisis in 1997, when
their crashing currencies ballooned the home currency value of their external debt.
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assets to increase by more than $500 billion. Nearly half of this offset was attributable to positive
valuation effects on U.S. foreign assets that were attributable to the dollar’s depreciation during
that year. In 2007, the impact of valuation changes, including $444 billion caused by dollar
depreciation, was sufficiently large to cause the U.S. net external debt to fall despite having to
finance a $638 billion current account deficit that year.27
World Commodity Prices (in Dollars) Tend to Increase
The fall of the dollar from 2002 to 2007 coincided with large increases in commodity prices. The
price of gold increased from about $300 per ounce to more than $600 per ounce, the price of oil
increased from about $20 per barrel to near $140 dollars per barrel, and the index of nonfuel
commodity prices rose about 85%.28 Because most commodities in international markets are
priced in dollars, their prices to the U.S. buyer are not directly affected by movements of the
exchange rate.
However, a 2008 IMF analysis argues that the dollar does have an indirect impact on commodity
prices, that works through at least three channels. First, a dollar depreciation makes commodities,
usually priced in dollars, less expensive29 in non-dollar countries, encouraging their demand for
commodities to increase. Second, a falling dollar reduces the foreign currency yield on dollar
denominated financial assets, making commodities a more attractive investment alternative to
foreign investors. Third, a weakening dollar could induce a stimulative monetary policy in other
countries, particularly those that peg their currencies to the dollar. A stimulative monetary policy
tends to decrease interest rates, which could stimulate foreign demand, including that for
commodities.
The IMF study estimated that if the dollar had remained at its peak of early 2002, by the end of
2007, the price of gold would have been $250 per ounce lower, the price of a barrel of crude oil
would have been $25 a barrel lower, and nonfuel commodity prices would have been 12%
lower.30
Other factors were likely more direct and important causes of the rapid climb of commodity
prices at this time. Large increases in world industrial production, particularly in emerging Asian
economies, have likely been a factor pulling up commodity prices. Also low interest rates in the
United States have reduced the incentive for current extraction over future extraction and
generally lowered the cost of holding inventories, dampening the supply response to higher
commodity prices.
27 Data for U.S. net external debt are compiled annually and the most recent estimate is for 2009. Data for 2010 is
scheduled to be released in July 2011. For further details on net external debt and valuation effects see U.S. Department
of Commerce, Bureau of Economic Analysis, U.S. Net International Investment Position, July 2010,
http://www.bea.gov/international/index.htm#bop.
28 IMF Primary Commodity Prices, February 2011, http://www.imf.org/external/np/res/commod/Table1-020911.pdf.
29 Assuming their currency is not pegged to the dollar.
30 International Monetary Fund, World Economic Outlook – April 2008, pp. 48-50.
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Other Possible Effects of Dollar Depreciation
Other impacts of a depreciating dollar are more problematic, but are potential risks.
U.S. Interest Rates Could Increase
A falling dollar itself does not directly affect interest rates in the United States. However, the
underlying international capital flows that influence the dollar may also influence conditions in
domestic credit markets. A weakening of the demand for dollar-denominated assets by private
investors tends to depreciate the dollar. A weaker demand for dollar assets is also a likely
consequence of a decrease in the net inflow of foreign capital to the U.S. economy. Other things
equal, a smaller net inflow of foreign capital reduces the supply of loanable funds available to the
economy, tending to increase the price of those funds, that is, increase interest rates.
At this time, however, other things are not equal. The economy, while recovering from the 2008-
2009 recession, still retains substantial economic slack and the demand for loanable funds by
businesses and households remains particularly weak. In addition, at least for the near term, the
Federal Reserve appears committed to a policy of monetary stimulus that will keep interest rates
low.31
However, as economic slack decreases as the recovery progresses, the Fed will likely steadily
reduce the amount of monetary stimulus and the domestic demand for credit will likely increase
to a more normal level, and together this will exert more upward pressure on interest rates. That
pressure will be greater to the degree that domestic savings does not increase sufficiently to offset
the reduced inflow of foreign capital (i.e., a reduced supply of loanable funds), making it likely
that, coincident with the falling dollar, U.S. interest rates would tend to rise more than they
otherwise would.
This added upward pressure on U.S. interest rates could be prevented if there was also an increase
in the supply of domestic saving generated by households and the government, sufficient to offset
the diminished inflow of foreign capital. Also, rising U.S. interest rates could feedback to
improve the relative attractiveness of dollar assets to some foreign investors, tending to slow the
net outflow of capital, decrease upward pressure on interest rates, and dampen the rate of dollar
depreciation. If, as noted above, the capital outflow is being motivated by other factors in addition
to the level of U.S. interest rates, then this feedback effect is not likely to stop the outflow, only
slow it.
Dollar’s Reserve Currency Role Could Be Reduced
Foreign central bank holdings of reserve currency assets have risen sharply over the past decade.
These “official holdings†have nearly quadrupled since 1997, increasing from about $2 trillion to
nearly $9 trillion by the end of 2010. Of the $5 trillion of official holdings of which currency
31Board of Governors of the Federal Reserve System, Monetary Policy Report to the Congress, March 1, 2011,
http://www.federalreserve.gov/monetarypolicy/mpr_20110301_part1.htm.
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composition is known, nearly $3 trillion (or 60%) is in dollar assets.32 Euro-denominated assets
have the second largest share at about 25%.
For the United States, there are significant benefits from the dollar being the world’s primary
reserve currency. Central banks’ demand for the reserve currency tends to be less volatile than
that of private investors. This stabilizes the demand for dollars and reduces the foreign exchange
risk faced by U.S. companies in their international transactions. Exchange rate risk is also
reduced because the United States borrows in its own currency, so that the appreciation of foreign
currencies against the dollar cannot increase debt-service cost or raise default risk. Another major
benefit of having the primary international reserve currency is that it enables the United States to
borrow abroad at a lower cost than it otherwise could. This cost advantage occurs because there is
a willingness of foreign central banks to pay a liquidity premium to hold dollar assets. Also, the
dollar’s status as the world’s reserve currency raises the incidence of foreigners using U.S. asset
markets. This added foreign involvement increases the breadth and depth of these markets, which
tends to attract even more investors, which further magnifies the benefits of issuing the reserve
currency.
However, the prospect of substantial further depreciation of the dollar could erode the dollar’s
ability to provide the important reserve currency function of being a reliable store of value.
Foreign central banks may see the erosion of this function as a growing disincentive for using the
dollar as their principal reserve currency. Another potential threat is any perceived
unsustainability of the U.S. long-term debt problem that may eventually result in a downgrading
of the U.S. sovereign-risk rating.
Yet, so far there appears to be only modest diversification from dollar assets by foreign central
banks. The dollar share of official reserves reached a peak value of about 72% in 2001. Over the
subsequent decade this share has slowly decreased, stabilizing at about 62% in 2009 and 2010.
The principal alternative to the dollar as a reserve currency has been the euro. Since its creation in
1999, the euro share of global official reserves rose from about 18% to 27% in 2007; however,
since then the euro has not increased its share of global reserve assets.33
Despite the problems posed for some by the dollar’s ongoing depreciation, at present there is
arguably no alternative currency to assume its role as principal reserve currency. The sovereign
debt crisis in Europe is likely to have diminished the euro’s attractiveness to central banks. In
addition, the size, quality, and stability of dollar asset markets, particularly the short-term
government securities market in which central banks tend to be most active, continues to make
dollar assets attractive. A further advantage is the power of “incumbency†conferred by the
important “network-externalities†that accrue to the currency that is currently dominant. Together
these factors will likely inhibit for the medium-term a large or abrupt change in the dollar’s
reserve currency status. Nevertheless, over the long-term, many economists predict that a
multiple currency arrangement is likely to emerge involving, in addition to the dollar, a continued
role for the euro and a substantially increased role of China’s yuan. This presumes that China will
be able to greatly improve the size and liquidity of its financial markets and create attractive
32 IMF, Currency Composition of Official Foreign Exchange Reserves, December, 2010, http://www.imf.org/external/
np/sta/cofer/eng/cofer.pdf.
33 Ibid, IMF.
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financial instruments. Sustained dollar depreciation could accelerate this process by encouraging
more active movement away from dollar assets by central banks.34
Risk of a Dollar Crisis Could Be Increased
Although asset market trade offers opportunities to raise overall economic efficiency and improve
the economic welfare of borrower and lender alike, trade in assets is prone to occasional
volatility, the disorderly resolution of which can lead to financial disruption and, more broadly, a
slowing of economic growth. The essential weakness of asset markets is that assets are a claim on
a stream of earnings over time—and the future is always uncertain. This can mean that relatively
small changes in investors’ beliefs about that future could have large effects on the value of the
asset. Historically, this has tended to make these markets much more volatile than goods markets,
in which value is generally far less contingent on the uncertainties of the future. Add to this the
often observed tendency for “herd-like†behavior among investors, particularly those focused on
the short run, and the volatility in asset markets can grow larger. Then add in leveraged purchases,
the inherent weakness of modern fractional-reserve banking, exchange rate risk, and the usual
problems of distance (i.e., different language, law, and business practices) and the potential for
volatility and crisis becomes even larger.
There is no precise demarcation of when a falling dollar might move from being an orderly
decline to being a crisis, but the depreciation would be significantly more rapid than the orderly
fall that has already occurred. The troubling characteristic of a dollar crisis would be that this
adjustment could move from orderly to disorderly, due to a precipitous decline in the willingness
of investors to hold dollar assets, causing a sharp decrease in the price of those assets and an
equally sharp increase in the interest rates attached to those assets. A sudden spike in interest rates
could slow domestic interest rate sensitive spending more quickly than the falling dollar can
stimulate net exports. This negative impulse could cause overall economic activity to slow,
perhaps to the point of stalling the economic recovery.
One factor governing whether dollar depreciation is an orderly or disorderly adjustment is
investor expectations about future dollar depreciation. Rational expectations will have a
stabilizing effect on the size of international capital flows. The rational forward-looking investor
will have some notion of the equilibrium exchange rate and whether the currency is currently
overvalued or undervalued. Such investors would only hold assets that have expected yields high
enough to compensate for the expected depreciation and also preserve a competitive rate of
return.
In contrast, a sharp plunge of the dollar could occur if most investors do not form rational
expectations about a likely future depreciation of the dollar. Once investors come to realize that
the dollar is falling at a faster rate than they had expected, there could be a sudden attempt by
large numbers of investors to sell their dollar assets. But with many sellers and few buyers, the
exchange rate would fall precipitously, along with the price of dollar assets, before stabilizing.
Some economists argue that foreign investors do not appear to have built a rational expectation of
future dollar depreciation into the nominal yields they are accepting to hold dollar assets. The
average nominal rate of return on low-risk treasury securities is currently about 2.5% and in 2010
34 For further discussion of this issue, CRS Report RL34083, The Dollar’s Future as the World’s Reserve Currency:
The Challenge of the Euro, by Craig K. Elwell.
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the dollar depreciated at about a 4% annual rate, so that the ex-post rate of return for foreigners
holding these securities has been negative.35
If many holders of dollar assets conclude their expectations for dollar depreciation had been too
low and try to move quickly out of dollar assets, the ensuing stampede could potentially cause a
dollar crisis. A buyer is needed to shed dollar assets, but in a crisis environment this may require a
precipitous bidding down of the price of the less desirable dollar assets. This leads not only to a
sharply falling exchange rate, but also to sharply rising interest rates in U.S. financial markets
(lower-asset prices translate into higher effective interest rates).
The dollar, of course, has been on a depreciating trend since 2002, and foreign investors have
continued to hold dollar assets for which the attached interest rate seems insufficient to
compensate for that depreciation. But there has been no dollar crisis. The avoidance of crisis is,
perhaps, explained in part by the large accumulation of dollar reserves by foreign central banks. If
foreign central banks have longer investment horizons than private36 investors, they will tend to
stabilize the demand for dollar assets. In general, the large size and stability of the dollar-asset
markets (along with the ongoing needs of central banks and other international investors) for
liquidity and a store of value undergirds the strong persistent international demand for dollar
assets.37
Policies That Could Influence the Dollar
Does the United States Have a Dollar Policy?
Treasury Secretaries have in the past asserted that the United States has a “strong dollar policy,â€
but have rarely taken direct steps to influence the dollar’s value.38 As noted earlier, since the 1973
demise of the Bretton Woods fixed exchange rate international monetary system, the de facto U.S.
dollar policy has been to let market forces determine the dollar’s value. The collapse of that
monetary system was to a large degree due to its increasing inability to maintain fixed-exchange
rates in the face of the massive growth of international capital flows in a reintegrated and rapidly
growing post-war global economy.39
35 U.S. Department of the Treasury, 2010 Average Historical Monthly Interest Rates, http://www.treasurydirect.gov/
govt/rates/pd/avg/2010/2010.htm.
36 Robert A. Mundell, “Capital Mobility and Stabilization Policy,†Canadian Journal of Economics and Political
Science, 29(4), 1963, pp 475-485.
37 For more discussion of this issue, see CRS Report RL34311, Dollar Crisis: Prospect and Implications, by Craig K.
Elwell.
38 See for example Keith Bradsher, New York Times, August 17, 1995, “Treasury Chief Says Strong Dollar Isn’t a
Threat to Trade,†http://www.nytimes.com/1995/08/17/business/international-business-treasury-chief-says-strong-
dollar-isn-t-a-threat-to-trade.html; USA Today, August 1, 2006, “ New Treasury secretary backs strong dollar, Social
Security solutionâ€, http://www.usatoday.com/money/economy/2006-08-01-paulson-speech_x.htm; and Tom Patrino,
Los Angles Times, November 12, 2009, “ Treasury Secretary Tim Geither pays lip service to keeping dollar strong,â€
http://articles.latimes.com/keyword/lip-service.
39 On post-war global capital flows and the demise of the Bretton Woods system, see Barry Eichengreen, Globalizing
Capital: A History of the International Monetary System( Princeton University Press, 1996), pp. 93-135.
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Mainstream economic theory suggests that a country cannot be open to large international capital
flows (as the United States is) and directly control both its exchange rate and its interest rates.
Because the management of interest rates is seen as central to the overriding policy goal of
stabilizing the domestic economy to maintain high employment and low inflation, the U.S.
Federal Reserve and the central banks of most other advanced economies control interest rates
and, therefore, have implicitly decided to let their exchange rates fluctuate, more or less, freely.
The exchange rate, while usually not the primary target, can be affected by macroeconomic
policies, such as quantitative easing, fiscal stimulus, and debt reduction. Its movement might well
support achieving these broader macroeconomic goals, but a particular level for the exchange rate
has not been an explicit policy goal in the United States. However, occasionally the government
has acted to directly influence the exchange rate. In addition, government policies, programs, and
institutions that undergird a “strong U.S. economy†arguably exert a indirect positive effect on the
dollar.
Policies to Influence the Demand for U.S. Assets
Given the importance of international asset markets in determining the dollar’s exchange rate,
policies aimed at directly or indirectly influencing the demand and supply of dollar assets would
potentially have the greatest direct impact on the dollar.
Direct Intervention in the Foreign Exchange Market
This policy involves the Federal Reserve at the request of the Treasury buying or selling foreign
exchange in an attempt to influence the dollar’s exchange rate. (This intervention will most often
be a sterilized intervention that alters the currency composition of the Fed’s balance sheet but
does not change the size of the monetary base, neutralizing any associated impact on the money
supply.) To strengthen the dollar, the Fed could attempt to boost the demand for dollars by selling
some portion of its foreign exchange reserves in exchange for dollars. (Sterilization in this case
would require the Fed to also purchase a like value of domestic securities to offset the negative
effect on the monetary base of its selling of foreign exchange reserves.)
The problem with intervention is that the scale of the Fed’s foreign exchange holdings is small
relative to the size of global foreign exchange markets, which have a daily turnover of more than
$4.0 trillion.40 Facing markets of this scale, currency intervention by the Fed would likely be
insufficient to counter a strong market trend away from dollar assets and prevent depreciation of
the dollar.
A coordinated intervention by the Fed and other central banks would have a greater chance of
success because it can increase the scale of the intervention and have a stronger influence on
market expectations. Since 1985, there have been six coordinated interventions: the Plaza Accord
of 1985 to weaken the dollar, the Louvre Accord of 1987 to stop the dollar’s fall, joint actions
with Japan in 1995 and 1998 to stabilize the yen/dollar exchange rate, G-7 action in 2000 to
support the newly introduced euro, and G-7 action in 2011 to limit appreciation of the Japanese
yen. All but the Louvre Accord do correspond with turning points for the targeted currencies.
40 Bank of International Settlements, Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives
Market, September 11, 2010, http://www.bis.org/press/p100901.htm.
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However, these interventions were most often accompanied by a change in monetary policy that
was consistent with moving the currencies in the desired direction. Many economists argue that
coordinated intervention in these circumstances played the useful role of a signaling device
helping overcome private investors’ uncertainty about the future direction of monetary policy and
the direction the central banks want the currency to move. But absent an accompanying change in
monetary policy it is unlikely that even coordinated intervention would be successful at altering
the exchange rate’s trend if it were being strongly propelled by private capital flows.
Monetary Policy
The Federal Reserve uses monetary policy to influence economic conditions. By increasing or
decreasing interest rates, it tightens or loosens credit conditions.
Changing the level of interest rates can also influence the dollar’s exchange rate. A tighter
monetary policy would tend to strengthen the dollar because higher interest rates, by making
dollar assets more attractive to foreign investors, other things equal, boosts the demand for the
dollar in the foreign exchange market. In contrast, lower interest rates would tend to weaken the
dollar by reducing the attractiveness of dollar assets. In either case, however, it would be
unprecedented for the Fed to use monetary policy to exclusively target the exchange rate, but it
could be the side-effect of policies aimed at controlling inflation or stimulating aggregate
spending to speed economic recovery.
In general, a floating exchange rate gives the central bank greater autonomy to use monetary
policy to achieve domestic stabilization goals. In the current macroeconomic situation, if the Fed
were obligated to prevent the dollar from depreciating, it would likely be constrained from
applying the degree of monetary stimulus needed to promote economic recovery.
It is likely that the Fed’s current policy of monetary stimulus to sustain economic recovery, by
keeping interest rates low, has exerted downward pressure on the dollar as well. Although not the
primary target of this monetary policy, the incidental depreciation of the dollar contributes to the
Fed’s stabilization goal of boosting economic growth by providing a boost to net exports.
Fiscal Policy and Federal Debt
Government choices about spending and taxing can also influence the exchange rate. Budget
deficits tend to have a stimulative effect on the economy. However, because the government must
borrow funds to finance a budget deficit, it increases the demand for credit market funds, which,
other things equal, tends to increase interest rates. Higher interest rates will tend to increase the
foreign demand for dollar-denominated assets, putting upward pressure on the exchange rate.
However, in the current state of the U.S. economy, with a sizable amount of economic slack and
weaker than normal private demand for credit market funds, current government borrowing does
not appear to have elevated market interest rates, and, therefore, does not appear likely to exert
upward pressure on the exchange rate. Moreover, the likely prospect of a slower than normal
economic recovery suggests a substantial amount of economic slack and relatively weak private
demand for credit is likely to persist over the near term. These conditions will continue to mute
the interest elevating effect of currently anticipated government borrowing and continue to exert
minimal upward pressure on the dollar.
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As economic recovery moves the U.S. economy closer to full employment and the private
demand for credit market funds increases, continuing large government budget deficits may result
in higher interest rates. Some foreign investors could be attracted by these higher interest rates,
increasing their demand for dollar assets. This would exert upward pressure on the dollar.
However, if the federal government does not implement a credible solution to its long-term debt
problem, it is possible that the expectation of persistent large budget deficits and sharply rising
public debt could degrade the expected long-term performance of the U.S. economy by crowding
out productive investment and slowing the pace of economic growth. This anticipated
deterioration could reduce international investors’ expected rate of return on dollar assets,
accordingly reduce the long-term demand for dollar assets. This reduced demand would exert
downward pressure on the dollar’s international exchange value.
Putting in place a creditable program of fiscal consolidation would also have an ambiguous effect
on the dollar’s longer-term path. Less government borrowing would tend to lower interest rates
and depreciate the dollar, while the improved prospect for long-term growth and expected rates of
return would tend to appreciate the dollar.
Policies to Increase the Demand for U.S. Exports
Policies that tend to increase the foreign demand for U.S. goods and services also tend to
strengthen the dollar.
Lower Foreign Trade Barriers
The continued existence of various trade barriers in many countries may keep the demand for
U.S. exports weaker than it otherwise would be. If lowering those barriers significantly boosts the
demand for U.S. goods and services, it would also exert some upward pressure on the dollar
exchange rate. It is difficult to judge how strong this upward pressure would be. Moreover, this is
not likely to be a readily implementable policy tool and probably has little near-term significance
for the dollar’s exchange rate.
Support for Development of New Products
If the United States has goods and services that are strongly in demand in the rest of the world,
there will be some upward pressure on the exchange rate. Economic theory suggests that the
government’s role in this process is to support those aspects of research and development that are
likely to be under-invested in by the private market. This type of policy would most likely have
long-run implications, but not have much effect on the near-term value of the dollar.
Indirect Government Influence on the Dollar
Over the long run, at least three factors will likely continue to indirectly support the international
demand for dollar assets: (1) the basic economic performance of the U.S. economy as measured
by GDP growth, productivity advance, and pace of innovation has for the past 25 years been
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The Depreciating Dollar: Economic Effects and Policy Response
superior to that of Japan and the major euro area economies;41 (2) the Fed is widely seen as a
credible manager of monetary policy and has a strong record of maintaining macroeconomic
stability; and (3) the large and highly liquid U.S. asset markets will likely continue to be an
attractive destination for foreign investors. Therefore, decisions by the 112th Congress regarding
policies that enhance or degrade any of these three attributes of the U.S. economy will
accordingly tend to indirectly strengthen or weaken the dollar’s long-term path. Of likely
immediate relevance is the near term issue of sustaining economic recovery and reducing
unemployment and the long-term issue of reducing the growth of federal debt.
Global Imbalances, the Dollar, and Economic Policy
As already discussed, the dollar’s exchange rate largely reflects fundamental economic forces,
particularly those that influence the demand for and supply of assets on international financial
markets. Currently, an examination of those forces highlights a large and potentially destabilizing
imbalance in the global economy: in the United States persistent large trade deficits and the
accumulation of foreign debt, and in the rest of the world large trade surpluses, weak domestic
demand, and the accumulation of dollar denominated assets. Most economists would argue that
this is a condition that carries more than a negligible risk of generating financial instability and
eventual global economic crisis.
To achieve an orderly correction of these imbalances that assures more stable exchange rates and
leaves all the involved economies on sounder macroeconomic footing, mainstream economic
thinking suggests that the needed rebalancing can be most efficiently achieved by a coordinated
international policy response, the salient elements of which are
• in the United States, raising the national saving rate via substantial increases in
the saving rates of households and government and through that reducing the
U.S. trade deficit to a “sustainable†size;42
• in Japan and Europe, generating faster economic growth primarily propelled by
domestic spending rather than net exports;
• in Asia (excluding Japan and China), fostering a recovery of domestic investment
and reducing the outflow of domestic saving; and
• in China (and other surplus economies that fix their exchange rates to the dollar),
allowing their currencies to appreciate and channel more of their domestic
savings into domestic spending.43
41 The World Economic Forum in its 2010 Global Competitiveness Report ranks the United States as the fourth most
competitive economy in the world and the United States has been at or near the top of this ranking since it began in
1979, http://www3.weforum.org/docs/WEF_GlobalCompetitivenessReport_2010-11.pdf.
42 A trade deficit is arguably sustainable if it does not cause the U.S. foreign debt/GDP ratio to rise. For the United
States a trade deficit as a percent of GDP of 2% or less would probably meet this sustainability criterion. For further
discussion of sustainability see CRS Report RL33186, Is the U.S. Current Account Deficit Sustainable?, by Marc
Labonte.
43 On global rebalancing, see for example: Olivier Blanchard, “Sustaining Global Recovery,†International Monetary
Fund, September 2009, http://www.imf.org/external/pubs/ft/fandd/2009/09/index.htm; “Rebalancing,†The Economist,
March 31, 2010, http://www.economist.com/node/15793036; and Board of Governors of the Federal Reserve System,
Vice-chairman Donald L. Kohn, Speech “Global Imbalances,†May 11, 2010, http://www.federalreserve.gov/
newsevents/speech/kohn20100511a.htm.
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The Depreciating Dollar: Economic Effects and Policy Response
A key attribute of such a rebalancing of global spending would likely be further
depreciation of the dollar. This outcome illustrates that an orderly depreciation of the
dollar can be, on balance, a beneficial attribute of policy adjustments and economic
changes that would ultimately improve economic conditions in the United States and
abroad. There is some evidence that a global rebalancing is in progress. In the United
States, the saving rate of households is up and the federal government seems to be
moving toward raising public saving by reducing its long-term deficit problem. In China,
the yuan has appreciated and the government’s recently released five-year plan points to
that country undertaking policies to raise its domestic consumption and narrow its global
trade surplus.44
Author Contact Information
Craig K. Elwell
Specialist in Macroeconomic Policy
celwell@crs.loc.gov, 7-7757
44 China Daily, October 28, 2010, “China’s Twelfth Five-Year Plan signifies a new phase in growth,â€
http://www.chinadaily.com.cn/bizchina/2010-10/27/content_11463985.htm and Martin Feldstein, “The End of China’s
Surplus, Project Syndicate, January 28, 2011, http://www.project-syndicate.org/commentary/feldstein32/English.
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