The Dollar and the U.S. Trade Deficit
Updated December 9, 2020
The Dollar and the U.S. Trade Deficit
Overview
trade deficit. Most economists also argue that attempting to
Since taking office, the Trump Administration has used the
alter the long-run exchange rate of the dollar that differs
overall and bilateral U.S. trade deficits as one of its
from its market price is difficult to sustain.
barometers for evaluating the success or failure of the
global trading system, U.S. trade policy, and trade
Exchange Rates and Capital Flows
agreements. In an effort to reduce the trade deficit and for
Exchange rates reflect the relative prices of currencies, and
other policy objectives, the Administration has renegotiated
changes in those rates can affect trade flows by changing
existing trade agreements, withdrawn from or suspended
export and import prices. As a result, an appreciation in the
negotiations on other trade agreements, initiated new
dollar relative to other currencies raises the dollar-
agreements, and placed tariffs on a range of imports.
denominated prices of U.S. exports. In contrast, a
Previous administrations and Members of Congress, while
depreciation in the dollar would have the opposite effect:
expressing concern, have not legislated policies specifically
export prices would fall and import prices would rise.
to reduce the trade deficit.
Under the current system of floating exchange rates,
The Trump Administration also has advocated for
extensive cross border capital flows, and the role of the
depreciating the dollar against other major currencies,
dollar as the dominant global currency, financial
reasoning that a weaker dollar would increase U.S. exports
transactions are a major factor affecting exchange rates and
and reduce the nation’s trade deficit. Additionally, the
current account balances. The balance of payments is a
Administration contends that certain countries are
system of off-setting accounts. Under this arrangement, a
manipulating their currencies to give their exports a price
surplus or deficit in the current account is offset by an equal
advantage. On February 3, 2020, the Commerce
transaction in the capital account, which is comprised of
Department issued a rule that allows currency manipulation
foreign deposits in U.S. banks, foreign purchases of U.S.
potentially to be considered as a domestic subsidy under
businesses and real estate, and foreign purchases of U.S.
U.S. countervailing duty laws. The International Monetary
government and corporate debt and equities. For some
Fund (IMF) concluded in its July 2020 report on external
analysts, the ability of the U.S. economy to finance its trade
balances that current accounts and currencies may be under-
deficits through such capital inflows reduces the constraint
or over-valued at times, but this largely reflected domestic
of domestic savings.
economic policies. Economists have raised concerns about
the broader long-term impact on the U.S. economy of
Most capital account assets are highly liquid and
financing trade deficits.
transactions respond rapidly to political and economic
events and instantaneously transmit market signals across
Origin of the Trade Deficit
national borders. As a result, shifts in the capital account in
Changes in exchange rates can affect trade balances through
response to market events can drive movements in the
changes in export and import prices and through changes in
exchange rate which, in turn, can affect the current account
asset prices and income flows. Most economists argue that
and the trade balance. From this perspective, efforts to
the U.S. trade deficit is largely the product of a low national
devalue the dollar likely would have an immediate impact
savings rate, attributed in part to U.S. macroeconomic
on capital flows and investor’s expectations that could
policy, or the combination of fiscal policy—notably large
blunt, or offset entirely, the intended change in the dollar’s
and persistent federal government budget deficits—and
exchange rate.
monetary policy. This combination of policies determines
the overall national saving-investment balance, which
Role of the Dollar
determines the inward and outward flows of funds that
Currently, the dollar effectively serves as the dominant
affect the value of the dollar and the U.S. trade balance.
global reserve currency. As such, the international value of
the dollar reflects a broad range of international and
Most economists argue that attempting to alter the current
domestic economic activities that can far outweigh the size
account balance (comprised of trade in goods, services, and
of domestic trade balances alone. On a daily basis, the value
official flows) and, by implication the trade deficit, without
of global foreign exchange transactions eclipses the total
addressing the underlying macroeconomic conditions,
global value of economic output and the value of all traded
likely will be counterproductive and create distortions in the
stocks and bonds. According to a recent survey, the dollar
economy. Also, most economists contend that, absent
accounts for 88% of daily global foreign exchange market
changes in the underlying macroeconomic conditions,
turnover of $6.6 trillion, or four times the annual amount of
targeting individual bilateral trade balances most likely will
U.S. exports of goods and services. The volume of dollar
result in trade diversion and offsetting changes in trade
turnover reflects its wide range of uses in international
balances with other partners, without altering the overall
financial transactions, including two-thirds of global central
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The Dollar and the U.S. Trade Deficit
banks’ reserves, broadly as an invoicing currency to fund
between 2011 and 2018 to -$887 billion as the dollar
international commercial activities, non-U.S. banks’ foreign
appreciated by 26%. Data indicate that the U.S. goods trade
currency holdings, and, non-U.S. corporate borrowings
deficit in 2019 was -$864 billion.
from banks and the corporate bond market. Also, a number
of internationally-traded commodities, such as crude oil, are
Figure 2. U.S. Goods Trade as a Share of GDP
priced in dollars.
Fundamentally, an appreciation of the dollar increases the
amount of foreign currency needed to acquire dollar-
denominated assets and, therefore, raises the price of U.S.
exports and potentially lowers export sales. On the import
side, an appreciation of the dollar lowers the price of
imports and makes imports cheaper for U.S. consumers. In
contrast, higher export prices reduce foreign purchases of
U.S. exports, potentially reducing U.S. economic activity.
Source: CRS. Data from Bureau of Economic Analysis.
Over the past two decades, the dollar has remained
relatively high on a real trade-weighted basis against other
Exchange rate-induced changes in export and import prices
major currencies, as indicated in Figure 1. From 2002 to
could alter the amounts, or volumes, of exports and imports,
2008, the dollar depreciated against other major currencies,
as consumers and businesses substitute for lower priced
but appreciated during the 2008-2009 financial crisis as
goods. Following an appreciation in the dollar, export
investors and others favored safe-haven currencies such as
volumes could fall and import volumes rise, which could
the dollar. Following the financial crisis, the dollar
increase the trade deficit. In contrast, a depreciation in the
depreciated between 2009 and mid-2011, returning close to
dollar potentially could reduce the trade deficit as export
its pre-crisis value. After appreciating between 2011 and
volumes increase and import volumes fall. As previously
2017, the dollar temporarily depreciated between 2017 and
indicated, however, this relationship has not held up well
2018, ostensibly due to stronger economic growth in
since 2013. A shift in trade volumes could be more directly
Europe, an appreciating Euro, and concern over U.S.
affected by the response in the capital account to changes in
economic growth. Through October 2020, the dollar first
the exchange rate.
appreciated during the pandemic-related global recession,
but then depreciated as demand lessened for the dollar as a
The analysis assumes that changes in the exchange rate will
safe-haven currency.
be fully passed along to consumers and producers and that
consumers and businesses will respond fully to changes in
Figure 1. U.S. $ Real Trade Weighted Broad Index
goods’ prices. To the extent that changes in the exchange
rate are not fully passed through to goods’ prices, trade
volumes would be less responsive to a change in the
exchange rate.
Exchange rates and trade balance linkages are also affected
by global value chains (GVCs) that are characterized by
trade in intermediate goods, or goods used as inputs to the
final production of goods and services. Trade in
intermediate goods means that imports are essential inputs
in the production of exports; measures to restrict imports
Source: CRS. Data from Federal Reserve.
invariably negatively affect exports. As a result, attempts to
depreciate a currency to promote exports invariably
The Merchandise Trade Account
increase domestic production costs and reduce exports.
In contrast to movements in the dollar’s exchange rate over
Select Issues for Congress
the past two decades, the U.S. merchandise trade deficit has
trended downward in nominal terms, but, at around 4% as a
If the trade deficit is the result of macroeconomic
share of U.S. GDP in 2019, has decreased slightly since
policies, as is generally accepted, what might be an
2013, as displayed in Figure 2. From 2002 to 2008, the
effective approach to reducing or ending the trade
dollar depreciated by 25% against the currencies of major
deficit?
trading partners, while the merchandise trade deficit
increased by 75%, from -$475 billion to -$833 billion,
Since the dollar serves as the dominant global reserve
seemingly at odds with the notion that a depreciating dollar,
currency, should Congress assess and evaluate what this
by itself, can stem the nation’s trade deficit. The U.S. trade
continuing role implies for the U.S. economy?
deficit reversed during the 2008-2009 financial crisis,
reflecting a contraction in global trade due to a decline in
James K. Jackson, Specialist in International Trade and
trade financing and a global economic recession. Between
Finance
2009 and 2011 the U.S. trade deficit increased by 11%.
Subsequently, the trade deficit increased another 20%
IF11430
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The Dollar and the U.S. Trade Deficit
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