Strong Dollar: Implications for U.S. Economy

Strong Dollar: Implications for U.S. Economy

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February 6, 2023
Strong Dollar: Implications for U.S. Economy
Over the past decade the U.S. dollar has generally increased
and financial markets. Such a global crisis tends to result in
in value relative to other currencies, reaching new heights
a “flight to safety,” whereby investors flock to the dollar,
since the beginning of the current economic expansion.
causing it to appreciate. This is what happened in early
This appreciation resulted from domestic and international
2020. As financial markets normalized, the dollar
economic conditions but also directly affects the U.S.
depreciated somewhat.
economy, notably in its effect on trade. This In Focus
discusses the recent strengthening of the dollar, potential
After a brief period of depreciation, the dollar again began
causes and effects, and policy implications.
to appreciate in 2021 and continued to do so throughout
most of 2022. A number of factors may have contributed to
Recent Trends
the appreciation since 2021, including the relative speed of
To determine the value of the dollar, economists compare it
economic recoveries, relative interest rate levels, and
to other currencies. These comparisons are known as
investor demand for U.S. assets. A prominent reason for the
exchange rates and measure how much of one currency a
appreciation in 2022 has been relatively fast-paced interest
unit of another currency can purchase.
rate increases in the United States compared to other
countries. In response to inflation, which began to rise in
To consider how the value of the dollar has changed over
2021, the Federal Reserve has been increasing its policy
time in relation to multiple currencies, the Federal Reserve
rate fairly aggressively, causing other interest rates in the
produces a number of indexes. One such measure, the broad
economy to rise as well.
dollar index, is shown in Figure 1. The Fed calculates the
broad dollar index using the currencies of major U.S.
Figure 1. Broad Dollar Index
trading partners (based on volume of bilateral trade). Based
January 2006 to January 2023
on this measure, in both real (inflation-adjusted) and
nominal (unadjusted) terms the value of the dollar has been
trending generally upwards (appreciating) since 2011,
peaking in October of 2022 and falling slightly
(depreciating) since then.
The broad dollar index only provides data back to 2006.
Using information from discontinued trade-weighted dollar
indexes, this episode is the third time since the United
States adopted a floating exchange rate regime in the 1970s
that the dollar has undergone extended periods of
significant appreciation—it also happened in the first half
of the 1980s and again in the second half of the 1990s to the

early 2000s.
Source: Federal Reserve H.10 Foreign Exchange Rates.
Causes of the Strong Dollar
Higher interest rates in the U.S. economy relative to foreign
economies make U.S. assets more attractive relative to
Since the fixed exchange rate regime ended in the 1970s,
foreign assets, causing investors to demand dollars to invest
the value of the dollar has been determined largely by the
in U.S. assets and the dollar to appreciate. For the dollar to
forces of supply and demand in foreign exchange markets.
remain strong, foreigners must be willing to continue to
Participants in these markets—which include a variety of
invest in U.S. assets despite the U.S. negative net
private investors, investment firms, private banks, and
international investment position (NIIP, the difference
central banks, among others—can buy, sell, and exchange
between how much U.S. investors have invested abroad and
currencies, which allows for international trade of goods
how much foreigners have invested in the United States) of
and services, foreign investments, and other cross-border
over $16 trillion. Foreigners may nevertheless be willing to
financial transactions. Factors that have contributed to the
continue investing because (1) the United States has long
dollar appreciation over the past decade include increases in
foreign investors’ net savings, relative increases in U.S.
had a negative NIIP and net capital inflows, (2) the United
States has consistently earned positive net income on its
interest rates, and increasing demand for U.S. assets.
NIIP despite it being negative, and (3) the dollar’s unique
role as the world’s reserve currency creates consistent
Most recently, dollar appreciation has been a result of
foreign demand to hold dollars for trade and as foreign
economic conditions and policy surrounding the COVID-19
exchange reserves. For more information, see CRS In Focus
pandemic. The pandemic spread globally in early 2020 and
IF11707, The U.S. Dollar as the World’s Dominant Reserve
caused deep disruption to the U.S. and foreign economies
Currency, by Rebecca M. Nelson and Martin A. Weiss.
https://crsreports.congress.gov

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Strong Dollar: Implications for U.S. Economy
Economic Effects of a Strong Dollar
of the dollar would also have short-term implications for
Because the value of the dollar is caused by economic
inflation, interest rates, output, and other effects.
conditions in the United States and abroad, one cannot
According to the Bank of International Settlements, foreign
characterize the strong dollar as good or bad for the overall
currency trading involving the dollar averaged $6.6 trillion
economy. However, the strong dollar does not affect all
per day in 2022, indicating that the exchange rate is
parts of the U.S. economy the same. Its effects are felt most
dominated by financial flows, as trade flows represent a
directly by the U.S. trade sector. All else equal, when the
fraction of that volume. This suggests that any effective
dollar is strong, U.S. exports are relatively expensive
policy to change the value of the dollar would depend on
compared to foreign-made goods and services, and foreign
reducing interest rates in the United States relative to the
imports to the United States are relatively inexpensive
rest of the world. (Stated differently, the dollar is likely to
compared to U.S.-made competing goods.
remain strong until U.S. interest rates fall relative to foreign
rates or foreign interest rates rise relative to U.S. rates.)
Thus, a stronger dollar tends to cause the trade deficit
(exports less imports) to increase. Generally, the trade
Theoretically, interest rates could be reduced through
deficit has been increasing as a share of gross domestic
monetary policy or fiscal policy. The effect of monetary
product (GDP) since the beginning of 2020 and has
policy on interest rates is more straightforward and
continued rising since the dollar continued its upward trend
predictable—but controlled by the Federal Reserve.
in 2021 (see Figure 2). The trade deficit was around 2.5%-
Furthermore, their implications for the economy are quite
3% of GDP from 2013 to 2019, then rose to a peak of 4.5%
different. Reducing rates through monetary policy would
of GDP in the first quarter of 2022, before falling to 3.2%
stimulate the economy, which would put more upward
of GDP in the third quarter.
pressure on inflation—already the highest it has been in
decades. By contrast, tightening fiscal policy (i.e., reducing
Figure 2. Exports, Imports, and Trade Deficit
the deficit) would be contractionary, which would mitigate
Q1 2006-Q3 2022
inflationary pressures and reduce interest rates. By reducing
the deficit, the U.S. Treasury would have fewer securities
for investors to purchase, who would therefore be willing to
hold Treasury securities at lower interest rates. Because of
the size and importance of Treasury markets, lower interest
rates on Treasury securities would feed through to other
interest rates throughout the economy. Depending on how
mobile capital is and how sensitive trade is to the value of
the dollar, a reduction in the trade deficit could potentially
offset some of the contractionary effects of deficit
reduction. For these effects to be noticeable, the deficit
reduction undertaken would have to be sizeable relative to
the overall economy.
This analysis also suggests that policy options that would
Source: CRS calculations of Bureau of Economic Analysis data.
not affect interest rates are less likely to have a lasting
effect on the value of the dollar. For example, trade policies
Other effects of a strong dollar may provide economic
to boost exports or restrain imports would be expected to
benefits. Cheaper imports allow U.S. consumers to
make the dollar stronger, therefore neutralizing their goals.
consume more, raising their overall purchasing power.
(By increasing export demand or decreasing import
Cheaper imports also allow U.S. businesses to purchase less
demand, such policies would also be increasing the relative
expensive raw materials and intermediate goods, which
demand for the dollar, thereby raising its value.) Other
companies would be expected to pass on to consumers in
policy options that do not involve changing interest rates
the form of lower prices if markets were competitive.
are discussed in CRS In Focus IF11296, U.S. Dollar
During a high inflation period, the strong dollar also
Intervention: Options and Issues for Congress, by Marc
mitigates inflationary pressures through lower import prices
Labonte and Martin A. Weiss.
and lower overall demand. In addition, if the value of the
dollar is being driven by capital inflows, then U.S. interest
Some commentators blame exchange rate intervention by
foreign governments (sometimes called “currency
rates would be higher in the absence of those capital flows.
manipulation”) for the strong dollar. But f
When there is an inflow of capital, borrowing becomes
oreign official
cheaper because the amount of loanable funds in the
holdings of Treasury securities and dollar-denominated
economy increases. Higher interest rates would reduce
official foreign exchange reserves have both been declining
interest-sensitive spending by U.S. consumers and
in nominal terms since 2021. This seems to rule out
businesses and make it more expensive to finance the
manipulation as a primary cause of the strong dollar over
federal budget deficit.
that period. For more information, see CRS In Focus
IF10049, Exchange Rates and Currency Manipulation, by
Policy Implications
Rebecca M. Nelson.
Policy options could be considered to change the value of
Marc Labonte, Specialist in Macroeconomic Policy
the dollar. Given that its value is tied to larger
macroeconomic forces, policy attempts to change the value
Lida R. Weinstock, Analyst Macroeconomic Policy
IF12319
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Strong Dollar: Implications for U.S. Economy

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