Weak Dollar, Strong Dollar: Causes and Consequences

Publication Date: May 2008

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Economics

Type:

Abstract:

After a long and large appreciation, in early 2002 the dollar peaked and has since then steadily weakened in value relative to other major currencies. A weaker dollar will be good news for exporters and those who compete with imports, while consumers of imports will be correspondingly unhappy. Yet it is important to recognize that a falling dollar is symptomatic of the ebb and flow of international capital in and out of the American economy. Those flows will have important implications for domestic interest rates and activities sensitive to credit conditions, such as housing and business investment.

The exchange rates movement will be strongly influenced by the effect of changes in interest rates on the flow of financial capital between countries. One also needs to consider how the expected movement of future exchange rates influences investors now. Inflation, safe-haven and speculative effects, and the size of the trade balance can also be important. The central role of relative interest rates in generating international capital flows and exchange rate movements makes it important to understand the forces that move interest rates. This points us toward an understanding of the demand for and supply of loanable funds. The economy's pattern of saving and investment will exert a strong force on interest rates. For the United States, a structural tendency for domestic savings to fall short of domestic investment leads to significantly higher interest rates when economic activity picks up speed. Government policy can also affect interest rates and the exchange rate. Large government budget deficits will tend to push up interest rates and the exchange rate. Budget surpluses have the opposite effect. Tight monetary policy tends to raise interest rates and the exchange rate. A stimulative monetary policy has the opposite effect. Recent U.S. economic history has demonstrated the great importance of these fundamental factors in determining the exchange rates path.

As we contemplate the significance of a weakening dollar, it is important to consider the effect of the outflow of foreign capital that causes that weakening on domestic investment and overall economic welfare. In the 1980s, macroeconomic policy had a substantial effect on the level of interest rates and the path of the dollar. Tight monetary policy and large budget deficits pushed interest rates and the dollar upward through 1985 and a reversal of those policies pushed interest rates and the dollar down over the last half of the decade. In the 1990s, a steady rise of the dollar from mid-decade on was primarily the consequence of an investment boom in the United States that kept rates of return high and attracted large inflows of foreign capital. In both of these periods upward pressure on the dollar was intensified by a persistently low U.S. saving rate and relatively weak economic performance abroad. The depreciation of the dollar since 2002 is likely the consequence of slower U.S. growth and a move toward a more diversified portfolio by foreign investors. The dollar's near-term path is probably downward, but important forces seem poised to put significant upward pressure on the dollar. This report will be updated as events warrant.