IWS Documented News INTERNATIONAL

IWS Documented News Service

_______________________________

Institute for Workplace Studies----------------- Professor Samuel B. Bacharach

School of Industrial & Labor Relations-------- Director, Institute for Workplace Studies

Cornell University

16 East 34th Street, 4th floor---------------------- Stuart Basefsky

New York, NY 10016 -------------------------------Director, IWS News Bureau

________________________________________________________________________

 

Congressional Research Service (CRS)

 

The Depreciating Dollar: Economic Effects and Policy Response

Craig K. Elwell, Specialist in Macroeconomic Policy

February 23, 2012

http://www.fas.org/sgp/crs/misc/RL34582.pdf

[full-text, 24 pages]

 

ummary

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, the United states may also

experience a 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 associated with the buying and selling of dollar

denominated goods, services, and assets (e.g., stocks, bonds, real property) on global 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.

 

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...................................................................... 11

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. Index of Trade-Weighted Exchange Rate of Dollar ......................................................... 2

 

Contacts

Author Contact Information........................................................................................................... 21

 

 

________________________________________________________________________

This information is provided to subscribers, friends, faculty, students and alumni of the School of Industrial & Labor Relations (ILR). It is a service of the Institute for Workplace Studies (IWS) in New York City. Stuart Basefsky is responsible for the selection of the contents which is intended to keep researchers, companies, workers, and governments aware of the latest information related to ILR disciplines as it becomes available for the purposes of research, understanding and debate. The content does not reflect the opinions or positions of Cornell University, the School of Industrial & Labor Relations, or that of Mr. Basefsky and should not be construed as such. The service is unique in that it provides the original source documentation, via links, behind the news and research of the day. Use of the information provided is unrestricted. However, it is requested that users acknowledge that the information was found via the IWS Documented News Service.