Weak Dollar, Strong Dollar Causes and Consequences

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After a long and large appreciation, in early 2002, the dollar peaked and steadily weakened in
value relative to other major currencies through 2004. In 2005 and through most of 2006, the
dollar was essentially steady. At the end of 2006, however, depreciation resumed and it has
continued in 2007. 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. Also 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 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.
As the significance of a weakening dollar is contemplated, 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 between 2002 and
2004 was likely the consequence of slower U.S. growth and a move toward a more diversified
portfolio by foreign investors. However, in 2005 the dollar strengthened again as foreign investor
demand for dollars was rejuvenated. Since then, weakening demand for dollar assets by foreign
investors has put the dollar on a downward path and important forces seem poised to continue to
put downward pressure on the currency. This report will be updated as events warrant.

Introduc tion ..................................................................................................................................... 1
What Determines the Dollar’s Exchange Rate................................................................................2
Demand, Supply, and the Dollar Exchange Rate......................................................................3
The Importance of Trade in Assets............................................................................................4
Expected Rate of Return and Asset Flows..........................................................................4
Diversification, Safe-Havens, and Official Purchases........................................................6
Fundamental Factors Determining the Level of Interest Rates.......................................................7
Capital Inflows, an Appreciating Dollar, and a Rising Trade Deficit..............................................9
The Ups and Downs of the Dollar: 1980 to 2007..........................................................................10
The 1980s.................................................................................................................................11
The 1990s................................................................................................................................12
The 2000s................................................................................................................................12
Instability and the Prospect of a Dollar Crash.........................................................................13
Where Will the Dollar Go.......................................................................................................15
Economic Policy and the Ups and Downs of the Dollar...............................................................16
Conclusion ..................................................................................................................................... 18
Figure 1. Real Trade -Weighted Dollar Exchange Rate..................................................................1
Author Contact Information..........................................................................................................19

From 1994 to early 2002, the real (inflation adjusted) trade-weighted dollar exchange rate (see ¹
Figure 1) appreciated nearly 30%. This appreciation occurred even as the U.S. trade deficit and
foreign debt climbed steadily higher. From 2002 to the present, the dollar, for the most part,
steadily depreciated, falling about 24%. From early 2002 through 2006, the dollar’s fall was
moderately paced at about 2.0% to 5.0% annually. Recently, however, the slide has accelerated,
falling nearly 10% between June of 2007 and June of 2008.
Figure 1. Real Trade -Weighted Dollar Exchange Rate
¹³⁰
¹²⁰
¹¹⁰
¹⁰⁰
⁹⁰
⁸⁰
⁷⁰
¹⁹⁸⁵¹⁹⁹⁰¹⁹⁹⁵²⁰⁰⁰²⁰⁰⁵
^Source:^{Board of Governor}^{s of}^{The Federal Reserve System}
The dollar’s fall from 2002 through early 2008 has not been uniform against individual
currencies, however. For example, it fell 44% against the euro, 36% against the Canadian dollar,
21% against the yen, and 17% against the yuan. These differing amounts of depreciation are in
part a reflection of how willing these countries have been to let their currencies fluctuate against
the dollar. The euro is free-floating, the yen has been moderately managed (mostly before 2005),
and the yuan is actively managed (rigidly fixed before 2005 and less rigidly fixed since 2005).
But it also reflects the structure of the international trade in assets, with larger effects occurring
on the exchange rates of countries with a high volume of asset trade with the United States. The
significance of the international trade in assets for exchange rates will be a central concern of this
report.
The strong dollar in the 1994-2002 period was certainly a benefit to U.S. consumers because the
rising exchange rate substantially lowered the price of foreign goods relative to the price of

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competing domestic products. However, the strengthening dollar was a growing impediment to
the sales of U.S. exporting and import competing industries because the price of their products
increased relative to those of foreign competitors. This also meant that as the dollar rose so did
the U.S. trade deficit. Conversely, a weakening dollar would be celebrated by U.S. exporters and
lamented by foreign exporters and domestic consumers. Further, a sustained dollar depreciation
could be expected to slow and then reverse the steady rise of the U.S. trade deficit. Also, a
depreciating dollar tends to improve the U.S. net debt position by raising the value U.S. foreign
assets. But a falling dollar also tends to raise the dollar price of commodities such as oil, metals,
and food.
The dollar, of course, is not just moving on its own. Appreciation and depreciation of the dollar
are most often a reflection of the ebb and flow of international capital in and out of the United
States as it is propelled by fundamental economic forces in the United States and abroad.
Moreover, these asset market events will have strong effects on economic activity in the United
States, activity seemingly unrelated to the dollars international exchange value. Because asset
market transactions most often occur at a higher volume and at greater speed than do transactions
in goods (i.e., imports and exports), most economists would argue that it is events in international
asset markets that “call the tune the dollar dances to,” and exports and imports of goods respond
accordingly.
This means that the net size and direction of these asset flows dictate the state of a country’s trade
balance. A country receiving a net inflow of capital will have an appreciating exchange rate and
run an equal sized trade deficit. In contrast, a country generating a net outflow of capital will have
a depreciating currency and run an equal sized trade surplus. The exchange rate moves to
equilibrate the inflow with the outflow of goods and assets. This also suggests that because the
ups and downs of the dollar are driven by asset flows in and out of the economy, these dollar
movements will be associated with impacts on domestic credit markets, affecting domestic
interest rates and, in turn, interest sensitive spending such as housing, consumer durables, and
business investment. Thus, while a rising dollar may be bad news for the tradeable goods sector,
it is likely good news for interest rate sensitive sectors and vice versa for a falling dollar.
The importance of U.S. international economic transactions to a healthy economy is well
recognized by Congress, which in recent years has closely monitored many dimensions of U.S.
trade performance. The dollar exchange rate, cross border financial flows, and the trade deficit are
known to be important to the functioning of the U.S. economy and for the implementation of
sound economic policy. These factors are also germane to an understanding the recent issue of
exchange rate manipulation by China and Japan. The determination of the dollar’s exchange rate
is, therefore, an ongoing area of congressional concern. This report provides background
information on the forces that most likely determine the path of the dollar exchange rate. The
report also considers recent events in international markets for goods and assets as well as suggest
what implications these forces carry for the state of the U.S. economy and for economic policy.

The exchange value of the dollar is determined by the interplay of the demand for and supply of
dollars in global foreign exchange markets. Prior to 1973, in the so-called fixed exchange rate era,
the dollar’s value was fixed at a rate established by international agreement, and the U.S. and
foreign governments were actively maintaining that fixed rate. This was accomplished by
monetary policy changing the level of domestic interest rates relative to foreign interest rates so

as to induce the buying or selling of dollar assets necessary to keep the exchange rate at the
mandated fixed rate. The fixed rate exchange rate regime grew increasingly untenable in part
because of the growing size and mobility of capital flows between countries. In the early 1970s,
the United States and many other nations changed by default to a “flexible exchange rate” system. ²
That system continues today.
With flexible exchange rates and wide-spread abandonment of capital controls the dollar is
largely free to move up or down as market forces dictate. In most circumstances the government
plays little or no direct day to day role in determining the dollar’s value relative to other
currencies. The government can certainly use macroeconomic policy to affect the market forces
that determine the exchange rate, but instances where the primary policy goal is the exchange rate
are relatively rare. The exchange rate is almost always subordinate to the goal of domestic ³
economic stabilization. But the exchange rate will certainly move as a collateral consequence of
pursuing other economic goals. On occasion, governments will intervene directly in the foreign
exchange market, buying or selling particular currencies to induce some adjustment of the
exchange rate, but such interventions are also infrequent and, when used, their impact on the
exchange rate is often problematic unless the intervention is supported by changes in
macroeconomic policy.
In this framework it is reasonable to infer that any observed weakening or depreciation of the
dollar is most likely the result of a reduced demand for dollars in the foreign exchange market, an
increased supply of dollars in that market, or some combination of both forces. Similarly, an
appreciating, or strong dollar, is the consequence of an increase in the demand for dollars, or a
decreased supply of dollars, or both in the foreign exchange markets. And most often these
changing market forces are the result of actions by private market participants rather than
government policy.
The demand for dollars for use in international exchange is a derived demand, driven by foreigner
demand for U.S. goods and assets, which of course are denominated in dollars and can only be
purchased with dollars. Therefore, to purchase U.S. goods or assets, a foreign buyer must first
exchange their home currency for dollars. Transactions in the foreign exchange market do not
involve the transfer of large parcels of paper currency between countries. These exchanges are
most often speedily achieved by the shifting of electronic balances between commercial banks or
foreign exchange dealers. With the purchase of a U.S. good or asset there has also been an
increase in the demand for dollars and an increase in the supply of foreign currency in the foreign
exchange market. Other factors unchanged, these actions repeated on a larger scale would tend to
increase the exchange value of the dollar relative to foreign currency. That is, the dollar will

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appreciate, meaning that each dollar can be exchanged for a greater amount of foreign currency,
and as a result command a greater volume of foreign goods or assets.
Similarly, when Americans buy foreign goods or assets they initiate a similar process; however, it
will have the opposite effect on the dollar’s exchange value. Exchanging dollars for a foreign
currency represents an increase in the demand for foreign currency and an increase in the supply
of dollars on the foreign exchange market. This type of transaction repeated on a larger scale
would tend to depreciate the exchange value of the dollar relative to foreign currencies, causing
each dollar to exchange for less of the foreign currency, and as a result to command a smaller
volume of foreign goods or assets.
The salient point is that the relative strength or weakness of the dollar will depend on the relative
strength or weakness of the demand of foreigners for dollar denominated goods and assets in
comparison to the strength of U.S. demand for foreign goods or assets.
A closer look at the dynamics of world trade today shows that the volume and speed of ⁴
international asset transactions far exceed that of goods transactions. It is estimated that the daily
global turnover on foreign exchange markets is near $2 trillion, with the dollar accounting for
90% of that. This compares with annual U.S. export sales of only $1.3 trillion. In addition, a very
large share of asset transactions can be done electronically and therefore move far more rapidly
than do transactions for goods, which will most often require a much slower physical transfer.
This size and speed means that at any point in time it is most likely that the relative demand for
assets here and abroad will be the dominant force in the foreign exchange market, transmitting the
essential energy that drives movement in the exchange rate for the dollar and other widely traded
currencies.
What determines the size and direction of cross-border asset flows? One can expect that 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. The level of nominal interest
rates can be used as a fairly reliable first approximation of the rate of return on assets that can be
earned in a particular country. Therefore, differences in the level of interest rates between
economies are likely to animate and direct international capital flows, as investors seek the
highest rate of return. When interest rates in the United States are significantly higher than
interest rates abroad, the demand for U.S. assets will, other factors unchanged, strengthen the
demand for those assets, increase the demand for the dollars needed to buy U.S. assets, and
appreciate the value of the dollar relative to foreign currencies. In contrast, if interest rates in the
United States are on average lower than interest rates abroad, the demand for foreign assets will
likely strengthen and the demand for U.S. assets will likely weaken. This will cause the demand
for foreign currencies needed to purchase foreign assets to strengthen and the demand for the
dollar will weaken, leading to a depreciation of the dollar relative to foreign currencies.

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Yet differences in nominal interest rates may not be all an investor needs to know to guide his/her
decision. Also consider that the return actually realized from an investment is paid out over some
future period. This means that the realized value of that future payment can be altered by changes
in other economic variables. Therefore, investor expectations of those future events will influence
the investors “expected pay off” and, in turn, the relative attractiveness of an asset. Two economic
variables of particular relevance to this decision are the expected change in the exchange rate
itself over the term of the investment and the expected rate of inflation.
Expectations about the future path of the exchange rate itself will figure prominently in the
investor’s calculation of what she will actually earn from an investment denominated in another
currency. Even a high nominal return would not be attractive if one expects the denominating
currency to depreciate at a similar or greater rate and erase all economic gain. On the other hand,
if the exchange rate is expected to appreciate the realized gain would be greater than what the
nominal interest rate alone would indicate and the asset looks more attractive.
The influence of exchange rate expectations can significantly complicate the task of judging how
exchange rates will move, as we can only imperfectly assess what informs those expectations and
the strength of their effect. It is also possible for exchange rate expectations to introduce some
degree of volatility into the exchange rate system, as “speculation” by some investors on the
future path of the exchange rate can push the currency, up or down, as speculative actions feed on
each other and generate “herd like” behavior. In these situations exchange rate expectations
become a sort of self-fulfilling prophecy that works to exaggerate the path the currency is already
set upon, pushing the currency well beyond what more basic fundamentals alone would dictate.
But this is going to be a bounded process. For at some point this speculative motive will also
likely work to counter the ongoing trend, as the risk versus reward calculus causes a growing
number of traders to doubt the likelihood of the dollar moving further on its current path and to
come to believe that depreciation is the more probable event. As might be expected, such
speculative behavior often makes it difficult to accurately predict the magnitude and duration of
exchange rate movements, particularly in the short run.
The impact of expected inflation on investor decisions is more indirect. To a foreign investor, the
U.S. rate of inflation would have little direct effect on the expected rate of return from a dollar-
denominated asset. The critical uncertainty for the foreign investor is the path of the exchange
rate, which will determine how any given dollar return will translate into his/her own currency.
However, relative inflation rates among nations can be a predictor of where and how much the
exchange rate will move in the future and, therefore, potentially relevant to the foreign investor’s
assessment of the expected return. If the United States has a lower inflation rate than that of a
trading partner, the dollar can be expected to appreciate relative to that currency by an amount
necessary to maintain parity in real purchasing power. If the United States has the higher rate of
inflation, then the dollar would tend to depreciate so as to maintain real purchasing power. In
other words, inflation differences will change the nominal exchange rate but not the real exchange
rate.
Another reason inflation may influence the demand for assets is that trends in the level of prices
can be a telling indicator of how well or poorly an economy is managed and whether the
investment climate will change for better or worse. Economies with accelerating inflation are
more likely to be ones that are poorly managed, with poor investment prospects; while economies
with stable or decelerating inflation may be seen as better managed and likely a more attractive
destination for investment. The aggressive and successful U.S. dis-inflation policy in the early

1980s may have contributed to the dollar’s sharp appreciation in this period. In recent years,

inflation in the United States has been consistently low and the current stance of the Fed gives no
indication that this pattern will change, making this factor of diminished importance for judging
recent and prospective movements of the dollar exchange rate. Changes in inflation trends in
other countries will still be a factor, however.
While relative levels of interest rates between countries and expected return are likely to be a
strong and prevalent force directing capital flows among economies, other factors will also
influence these flows at certain times. For instance, the size of the stock of assets in a particular
currency in investor portfolios can cause a change in investor preferences. Prudent investment
practice counsels that one’s portfolio should have an appropriate degree of diversification, across
asset types, including the currency in which they are denominated. Diversification spreads risk
across a wider spectrum of assets and reduces over exposure to any one asset. Therefore, even
though dollar assets may still offer a high relative return, if the accumulation has been large, at
some point foreign investors, considering both risk and reward, will decide that their portfolio’s
share of dollar denominated assets is large enough. To improve the diversity of their portfolios,
investors will slow or halt their purchase of such assets. Given that well over $8 trillion in U.S.
assets are now in foreign investor portfolios, diversification may be an increasingly important
factor governing the behavior of international investors toward dollar assets.
There is also likely to be a significant safe-haven effect behind some capital flows. This is really
just another manifestation of the balancing of risk and reward by foreign investors. Some
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. In recent decades 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 size of the safe-haven effect is not
easy to determine, but the disproportionate share of essentially no risk U.S. Treasury securities in
the asset holdings of foreigners suggests the magnitude of safe-haven motivated flows is probably
substantial and must exert a bias toward capital inflows and upward pressure on the dollar.
Governments through their central bank also often purchase international assets for reasons apart
from rate of return. From 2002 to 2007, the IMF reports that official holdings of foreign exchange
reserves world-wide increased from about $2 trillion to nearly $6.4 trillion. The dollar’s status as
the dominant international reserve currency has resulted in a large portion of the accumulation
being held in dollar denominated assets. For the $4 trillion of official holdings whose currency ⁵
composition in known, nearly $2.6 trillion is in dollar assets. In addition, the U.S. Treasury
reports that through 2007, $1.3 trillion or 26% of the $5 trillion outstanding marketable Treasury ⁶
securities were being held as foreign official reserves.
Official purchases can serve two objectives. One, the accumulation of a reserve of foreign
exchange denominated in readily exchangeable currencies such as the dollar to afford
international liquidity for coping with periodic 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 can not fully depend on international capital

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markets for such finance. In the wake of the Asian financial crisis of the late-1990s, many
emerging economies around the globe have over the last few years built up large stocks of foreign
exchange reserves, in large part denominated in dollars.
Two, official purchases are used to counter the impact of capital flows that would otherwise lead
to unwanted changes in the countries exchange rate. This is a common practice for many east
Asian economies who buy and sell foreign assets to influence their currencies exchange rate
relative to the dollar and other major currencies to maintain the price attractiveness of their
exports. In recent years, China and Japan have both been highly visible practitioners of
international asset accumulation to stabilize their exchange rates relative to the dollar. In 2007,
Japan held foreign exchange reserves valued at about $900 billion, an increase of $500 billion
since 2002. Similarly, in 2007, China held foreign exchange reserves valued at more than $1
trillion, an increase of nearly $750 billion since 2002. India, Korea, Taiwan, and Russia also
amassed sizable amounts of foreign exchange in this period. 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. It is estimated that 30% to 40% of the worldwide ⁷
increase in foreign exchange reserves since 2000 are of dollar assets.
Given the importance of expectations in decision making and the speed with which many asset
transactions can occur, exchange rates can be volatile and predicting the magnitude and duration
of short-run exchange rate movement with precision is a very elusive goal. But broad, long-term
trends can most often be explained by assessing the fundamental macroeconomic forces that
affect the relative level of interest rates and the expected rate of return between the United States ⁸
and the other major economies.

Changes in the level of interest rates are usually central to understanding movement of the
dollar’s exchange rate. So what factors are likely to move interest rates up or down? Again, the
level of interest rates is largely a market driven phenomenon governed by the demand for and
supply of loanable funds.

⁷^Se^e^C^R^S^R^e^por^{t R}^S²¹⁹⁵^1,^Fi^na^nc^ing^the^U^.^S.^Tr^ade^D^e^fic^it:^Rol^e^{of F}^o^r^e^{ign G}^o^v^e^r^nm^eⁿ^ts^,^by^Mar^c^L^a^bonte^a^nd
^G^a^{il E. Ma}^kⁱ^ne^n.
⁸^T^h^e^is^s^u^e^of^e^x^c^h^aⁿ^g^e^ra^te^v^o^la^tility^ha^s^be^eⁿ^the^f^o^c^u^s^of^m^u^c^h^di^s^c^us^sⁱ^{on a}^m^ong^e^c^onom^is^ts^{. Cont}^ra^r^y^to
^e^x^pe^c^t^a^{tion, e}^x^c^h^aⁿ^g^e^ra^te^{s ha}^v^e^be^eⁿ^m^u^c^h^m^o^re^v^o^la^tile^sinc^e^th^e^de^mⁱ^se^o^f^the^Bre^{tton W}^o^{ods sy}^ste^m^{. T}^h^e^r^e^a^r^e
^tw^{o pr}^incⁱ^pa^{l e}^x^plaⁿ^a^t^ions^{. T}^h^e^r^e^is^aⁿⁱ^nhe^r^e^nt^te^nde^nc^y^f^o^r^“^o^v^e^r^s^hoot^ing^”^of^e^quilⁱ^brⁱ^u^m^{in the}^s^e^m^a^r^k^e^t^s^or
^e^x^c^h^aⁿ^g^e^m^a^rk^e^t^s^a^r^e^s^ubje^c^t^{to l}^a^rg^e^s^c^a^l^e^“^d^e^s^ta^biliz^ing^s^p^e^c^u^la^ti^on.”^F^o^{r t}^h^e^c^r^e^a^t^ors^of^the^Bre^t^t^o^{n W}^oods^s^y^s^t^em
^the^de^le^te^rio^u^s^e^f^fe^c^t^s^of^de^s^t^a^b^iliz^ing^s^p^e^c^u^la^tio^{n w}^e^re^thoug^ht^to^be^s^ubs^taⁿ^tia^{l a}ⁿ^{d a}ⁿ^im^portaⁿ^t^re^a^s^{on f}^o^r^no^t
^allo^wⁱⁿ^g^ex^ch^an^g^e^rat^e^{s to}^f^l^o^a^{t. In}^recen^{t y}^{ears, th}^{e lo}^cu^{s o}^f^o^pⁱⁿⁱ^oⁿ^h^a^{s sh}^if^ted^m^o^{re to}^w^a^rd^th^{e d}^e^s^t^ab^ilizin^g
^sp^ecu^latioⁿ^ex^p^l^an^atioⁿ^{as ev}^id^en^{ce o}^fⁱⁿ^v^e^sto^r^irratioⁿ^a^lity^h^a^{s accu}^m^u^lated^.^T^h^{e effect o}^f^v^o^latility^oⁿ^t^h^{e p}^r^{ices an}^d
^v^o^lum^e^s^of^g^oodsⁱⁿ^w^o^{rld tra}^d^e^s^e^em^s^{to ha}^v^e^be^eⁿ^s^m^a^{ll, how}^ev^{er. T}^h^e^e^nha^nc^e^d^a^b^ility^{to he}^dg^e^e^x^c^h^aⁿ^g^e^ra^te^ris^k
^{in m}^ode^rⁿ^m^a^r^k^e^t^s^m^a^y^ex^plaⁱ^{n t}^h^is^s^m^a^{ll ef}^f^e^c^t^{. I}^t^is^e^x^pe^c^t^e^d^tha^t^e^c^onom^ie^s^w^{ith la}^r^g^e^tr^a^d^e^s^e^c^t^o^r^s^,^s^u^c^h^a^s^t^hos^eⁱⁿ
^Euro^pe^{, w}^{ill f}ⁱ^{nd v}^o^la^tile^e^x^c^h^aⁿ^g^e^ra^te^s^m^o^re^dis^r^upt^iv^e^thaⁿ^w^{ill e}^c^onom^ie^s^w^{ith re}^la^tiv^e^l^y^s^m^a^{ll trade}^s^e^c^t^ors^,^s^u^c^h
^a^s^the^Unite^d^Sta^t^e^s^{. Ye}^{t, w}^h^a^t^e^v^e^r^c^o^{sts e}^x^c^h^aⁿ^g^e^ra^te^v^o^la^tilit^y^doe^{s c}^a^u^se^m^u^{st be}^ba^la^nc^e^d^a^g^aⁱ^{nst the}^c^o^nside^r^a^b^le
^be^ne^f^{its of}^libe^r^a^liz^e^d^inte^rna^tⁱ^oⁿ^a^{l c}^a^p^ita^{l f}^l^ow^s.

On the demand side of the loanable funds market we look for changes in the forces that
commonly influence the use of credit. A strong, briskly growing economy with rapidly expanding
investment expenditure can be expected to have a rising demand for loanable funds and exert
upward pressure on interest rates. In contrast, economic weakness and attenuated investment
opportunities would tend to exert downward pressure on interest rates. In addition to the vigor of
the private economy, the demand for loanable funds and the level of interest rates can be
influenced by the balance of the government budget. Government budget deficits mean that the
public sector must borrow to fully fund its expenditures. Such borrowing is a demand for loanable
funds and can certainly influence the level of interest rates in the market. Any movement toward
larger budget deficits tends to exert upward pressure on interest rates and movement toward
smaller deficits would have the opposite effect. Of course, these outcomes will be tempered by
the economy’s position in the business cycle. In or just after a recession when the demand for
loanable funds is weak, these elevating effects on interest rates would be nil, but would become
increasingly manifest as an economic expansion matures.
Of primary importance on the supply side of the market for loanable funds is the nation’s rate of
saving. That flow represents the portion of current income that the economy has diverted from
spending on current consumption and provides a supply of loanable funds, available to finance
current investment expenditures. For any given level of demand for loanable funds, one can
expect that a higher rate of saving would likely lead to a lower level of interest rates than would a
lower rate of saving. Domestic saving can be augmented by an inflow of foreign saving, which is
precisely what the capital inflows are. But that inflow will be primarily a response to pressures
and incentives initially generated by the relative size of domestic saving and investment. And, of
course that response will move the exchange rate.
One of the more significant macroeconomic characteristics of the U.S. economy to emerge over
the past 25 years is the economy’s low and declining domestic saving rate. That rate has fallen ⁹
from about 20% of GDP in the 1970s to nearly 13% today. For comparison with other advanced
economies, the saving rate for Canada is 24%, for the euro area it is 21%, and for Japan it is 27%.
A persistently low saving rate in the United States creates a significant structural bias toward
relatively high interest rates during periods when economic activity and, in turn, the demand for
loanable funds is on the rise. In these periods, it is expected that the dollar exchange rate will
likely rise as an increased flow of foreign capital is attracted by those relatively high interest
rates.
Government can also influence interest rates from the supply side of the loanable funds market.
On the fiscal policy side, whereas budget deficits are an absorber of saving, budget surpluses are
government saving that augments the economy’s supply of loanable funds. Therefore, any move
toward larger budget surpluses (or smaller deficits) will exert downward pressure on interest
rates, while smaller surpluses (or larger deficits) tend to increase interest rates. Monetary policy
can influence the level of interest rates through its governing of the financial intermediation
activities of the banking system. A large share of the nation’s saving is channeled to borrowers by

⁹^Se^e^C^R^S^R^e^por^{t R}^L³⁰⁸⁷³^,^Sa^vi^ngⁱⁿ^t^h^{e U}ⁿⁱ^t^e^d^S^t^a^t^es:^Ho^w^Ha^{s I}^t^C^h^an^g^e^d^an^{d Wh}^{y I}^s^I^t^I^m^po^rt^an^t^?^,^by^B^r^ia^{n W}^.
^Ca^she^{ll a}^{nd G}^a^{il E. Ma}^kⁱ^neⁿ^.

banks. By altering the reserve position of banks, the monetary authority can alter the level of
loanable funds they will have available for extending credit and thereby the level of short-term
interest rates. A restrictive monetary policy tends to raise interest rates, while a expansionary
monetary policy tends to lower interest rates. Also, monetary policy, less encumbered by
administrative and political constraints, is in practice a more flexible tool than is fiscal policy and
will be used more often to implement macroeconomic policy, particularly in the short run.
This policy involves the Federal Reserve buying or selling foreign exchange in an attempt to
influence the 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 would 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 will be small relative to the size of global foreign exchange
markets which have a daily turnover of more than $3 trillion. Facing markets of this scale,
currency intervention by the Fed would likely be insufficient to counter a strong market trend
away from dollar assets.
A coordinated intervention by the Fed and other central banks has a greater chance of success
because it can increase the scale of the intervention. Since 1985 there have been five 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, and G-7 action in 2000 to support the newly introduced euro. All but the Louvre Accord do
correspond with turning points for the targeted currencies. 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 path if it were
being strongly propelled by private capital flows.

Also, as cross-border asset flows move the exchange rate, it has an impact on trade in goods. An
appreciating dollar makes U.S. exports more expensive to foreign buyers and imports less
expensive to domestic buyers. With net inflows of foreign capital and a rising exchange rate the
trade balance will move toward deficit as export sales weaken and import sales strengthen. The
size of the deficit in goods trade will generally be equal to the size of the net inflow of foreign
capital, with the dollar’s exchange rate working as the equilibration mechanism.

This sequence makes sense if you consider that a net inflow of foreign capital to the United States
represents a net transfer of purchasing power from foreign economies to the United States.
However, that purchasing power is denominated in a foreign currency and can be used only to
purchase foreign goods. Of course, this process works in the opposite direction for countries that
have a net capital outflow. They will experience a depreciating currency and a surplus in goods
trade commensurate with the size of the capital inflow. A net capital inflow means a country has
sold more assets to foreigners than it has purchased from foreigners or is running a surplus in its
asset account. By the same reasoning, a net capital outflow will represent a deficit in its asset
account. Thus, across both goods and assets transactions trade is always balanced, a surplus in
asset trade must balance a deficit in goods trade, and vice versa.
As expected, those whose economic activities are sensitive to credit market conditions and the
level of interest rates will find the forces causing the appreciating dollar to be favorable to their
economic well-being. Similarly, those who export or who must compete with imports will find
these circumstances unfavorable to their economic well-being. It is often argued that the trade
deficits that accompany a strong dollar also tend to increase the prospect of the nation
implementing protectionist policies. Such policies do not change the forces causing the net inflow
of capital and, therefore, will not change the trade deficit, but ultimately will impose costs on the
economy that exceed any benefits gained.
As with most economic events, there are benefits gained from capital inflows, but at some cost.
The strong dollar and its attendant capital inflows was a valuable support to domestic investment
activity in the 1990s. Higher investment will boost economic growth and improve economic well-
being. Without the capital inflow, U.S. investment would have been lower and the future benefits
to our living standard reduced. Some of those benefits flow to foreigners who own U.S. assets,
but the economy is better off than it would be without the capital inflow. The salient point is that
the strength or weakness of the dollar is not necessarily a positive or a negative event, but rather a
manifestation of an underlying economic process that helps some, hurts others, but on balance ¹⁰
may often bring a net benefit to the overall economy. As with many other things, economic
virtue need not occur at the extremes of no capital inflows and no capital outflows, but at some
intermediate point were the benefit and cost of international capital flows are equal. However,
judging this “golden mean” is difficult.

It is revealing to examine the general path of the dollar since the 1980s in the framework outlined
above. In both the 1980s and the 1990s, the dollar soared to record highs but for different reasons. ¹¹
It will also be revealing to see what caused the dollar to fall.

¹⁰^For^a^f^u^lle^r^dis^c^us^sⁱ^oⁿ^of^tr^a^d^e^d^e^fⁱ^c^its^{, s}^e^e^C^R^S^R^e^por^{t R}^L³¹⁰³^2,^The^U^.^{S. Tr}^ade^D^e^fic^it:^C^aus^e^s^,^C^ons^e^que^nc^e^s^,
^and^C^u^r^e^s^,^by^Craⁱ^g^K^.^El^w^e^ll.
¹¹^T^h^e^dis^c^us^sⁱ^onⁱⁿ^this^s^e^c^tio^{n f}^o^l^l^ow^s^tha^t^f^oundⁱⁿ^P^a^{ul K}^r^ug^m^aⁿ^a^{nd Ma}^ur^ic^e^O^b^s^t^f^e^ld,^Iⁿ^te^rⁿ^ati^o^{nal Ec}^on^om^ic^s^:
^The^o^r^y^a^nd^Polic^y^(New^Yo^rk^{, NY: Harp}^er-Co^lliⁿ^s^{, 1}⁹⁹⁸^),^p^p^{. 5}⁷⁷^-⁵⁸⁶^.

During the 1980s, the dollar exchange rate followed a path of sustained and substantial
appreciation followed by sustained and substantial depreciation. The dollar actually began its
ascent in 1979 in response to a sharp tightening of monetary policy, which pushed up domestic
interest rates. The Fed’s goal at this time was not dollar appreciation, but to rein in the double
digit inflation afflicting the economy. Nevertheless, as the markets came to appreciate the Fed’s
resolution in fighting inflation and the likely dual prospect of steadily rising interest rates and
decelerating inflation, the United States became an attractive destination for foreign investment.
The long recession from 1981 to 1983 did not do much to abate the dollar’s rise. But the new
Reagan Administration’s fiscal policy would give a sharp upward push to the dollar as the
economic recovery commenced in 1983. Sizable tax cuts along with large increases in defense
spending generated large federal budget deficits. That federal borrowing increased the demand for
a shrinking pool of domestic saving and added to the upward push on interest rates. Capital
inflows increased and the dollar climbed higher. It is also likely that once the dollar’s rise
appeared relatively steady, a strong round of speculative buying of dollar assets exacerbated the
appreciation of the exchange rate. The dollar peaked in 1985, about 50% above its level in 1979.
The next half of the decade would see depreciation of the dollar that was nearly as large. What
caused the change? One factor, difficult to isolate precisely, was a turn in the speculative belief
that the dollar would continue to rise. At this point, a sufficient number of investors came to
believe that the dollar was far above a sustainable level and was now more likely to depreciate
than appreciate. Of far more importance to the process of depreciation, however, was a change in
economic policy. Investor expectations were given reinforcement by sizable currency
interventions by the U.S. and other major economies aimed at weakening the dollar. Whatever the
actual effectiveness at changing the exchange rate, these interventions could be taken by
international investors as a strong signal as to where the government wanted the dollar to go and
that more fundamental changes in macroeconomic policy would support that desire. The Fed
moved toward a more stimulative monetary policy that pushed interest rates down. Fiscal policy
also slowly began to change toward a lower interest rate track, cutting the size of budget deficits
over the last half of the decade.
The depreciation of the dollar during 1986, 1987, and 1988 was precipitous, falling to about 40%
of its peak value in 1985 and below its 1979 level. In fact, the concern among policy makers here
and abroad was that the dollar would fall too far and needed to be stabilized. Particularly, in 1986
and 1987, the United States and other governments made active use of intervention policies in an
attempt to halt the dollar’s slide. How effective these policies were is unclear, but for this or other
reasons the dollar did enter a period of relative stability. This was interrupted in late 1987, when
the Fed moved aggressively to counter the depressing effects of that year’s stock market crash.
Reserves were pumped into the financial system and interest rates fell and with them so did the
dollar in 1988. For the remainder of the decade the dollar would not experience any sharp
movements, remaining relatively weak.
On balance, the decade showed us that strong dollar trends were not haphazard, but were broadly
predictable responses to changes in economic fundamentals that influence the expected rate of
return on dollar denominated assets. Moreover, in this period those changes were largely induced
by changes in macroeconomic policy. However, the structural fact of the low U.S. saving rate
clearly influenced the economic events in this period.

The 1990s began in economic weakness. The pace of economic growth decelerated sharply in

1990 and the economy fell into recession in 1991. In response to the weakening economy,

monetary policy turned to a more stimulative stance and the federal budget deficit grew as
economic weakness automatically increased government spending and dampened tax receipts.
Interest rates in the United States fell. In contrast, economic activity abroad was moving
relatively briskly. In this environment, the demand for dollar assets ebbed and the dollar exchange
rate fell, depreciating about 15% between 1989 and 1992. In 1992, an economic recovery got
underway in the United States, but abroad economic conditions weakened substantially. This
change in relative economic performance was enough to induce a moderate appreciation of the
dollar, but it remained well below the values of the 1980s.
By mid-decade, however, the pace of economic growth in the United States accelerated greatly.
What lay behind this change to faster growth was a sharp increase in the pace of investment
spending by business and a marked acceleration in productivity growth. The confluence of strong
consumer demand, deregulation, trade liberalization, and a rush to more fully integrate computers
and information technology into the production process propelled investment spending up at a
record pace. Expenditures on new plant and equipment went from about 13% of GDP in 1993 to
average over 20% of GDP for the remainder of the decade. But even with the move of the federal
budget towards surplus, the flow of domestic saving could not keep pace with investment and
interest rates edged up. Couple this bourgeoning saving-investment gap with a falling rate of
inflation, and juxtapose the exuberant economic conditions in the United States with very weak
economies abroad, and the United States became a very attractive destination for foreign
investors. A quickly rising foreign demand for dollar denominated assets would push the dollar
steadily higher, rising over 30% from 1995 through 2001. With the strongly appreciating dollar,
the trade deficit increased to a record high.
This time the dollar’s sharp ascent was driven by the private sector. Economic policy moved in
conflicting directions, probably making its net impact on the dollar a minor one. The
government’s move toward budget surpluses certainly added to national saving and likely muted
the dollar’s rise, but this was unlikely the immediate goal of this policy change. In contrast, the
Fed implemented a steadily more restrictive monetary policy that increased interest rates and this
may have added to the dollars upward momentum. Again, the Fed’s primary goal was to slow a
very fast moving economy and head off any re-acceleration of inflation. A rising dollar’s pushing
down of import prices was supportive of this anti-inflation goal and made the Fed’s task easier,
but the Fed was not the principal force behind that appreciation.
A rising dollar and the growing net inflow of borrowing that pushes it is unlikely to be sustainable
indefinitely. Borrower and lender alike may find good reasons to reduce the size of the capital
inflow. For the lender, rising risk and the imperative of adequate portfolio diversification can
prompt a diminished willingness to acquire dollar denominated assets. For the borrower, a rising
burden of debt service (current and prospective) may curb the desire to borrow. And, of course, if
the capital inflow is not checked by changes in private market decisions, it can be changed by
macroeconomic policy.

Perhaps more fundamentally, it is important to consider that given the magnitude of dollar assets
that have accumulated abroad, foreign investors would be ready to seek a greater degree of
diversity in their portfolios and are now moving out of dollar assets. Our knowledge of foreign
investor portfolios is limited, but a 2003 survey by The Economist magazine shows that American
assets make up 53% of the typical foreign investor’s equity portfolio and 44% of the typical bond
portfolio. As recently as the mid-1990s, these percentages where only about 30%. It has also been
estimated that the average investor since 2001 has allocated about 80% of his increased wealth to ¹²
dollar assets. Considering that historically investors have shown a marked preference for home
assets, rarely letting the foreign share in their portfolios rise above 30%, then one might
reasonably conclude that the holdings of U.S. assets had so greatly reduced portfolio diversity
that the saturation point had been reached. In any event, total net purchases of U.S. assets by
private foreign investors fell from $460 billion in 2002 to $186 billion in 2004.
The effect of this swing in private foreign investor behavior on the dollar, however, has been
muted but not offset by the counter effect of large foreign official purchases of dollar assets. In
the same time period, net official purchases of dollar assets increased from $111 billion to $399
billion.
In 2005, however, the dollar changed course and slowly but steadily appreciated in value, up 7%
in the major currencies index and about 2.3% in the broad index. The appreciation was much
more sizable against individual currencies, up about 14% against the yen and 11% against the
euro, but appreciated little or not at all against the currencies of China and several other Asian
economies that maintain their currencies at a fixed rate to the dollar. This appreciation occurred
even as the U.S. trade deficit and foreign debt climbed to record levels. This appreciation was
rooted in a sharp bounce-back of the demand for dollar denominated assets by foreign purchasers.
The net inflow of foreign funds jumped from $186 billion in 2004 to a record $585 billion in
2005. The motivating forces included continued strong U.S. economic growth relative to the rest
of the world, further Fed induced increases in domestic interest rates, and rising profits of oil-
exporting countries in need of a safe and liquid means of wealth storage. Also, the demand for
dollar reserves by foreign central banks, although down from that of 2004, remained strong in

2005.

Through mid-2006, the dollar was steady, responding to the halt of short-term interest rate
increases by the Fed and to a moderation of petro-dollar inflows. But, since then, the dollar has
depreciated about 12% and is now down about 24% from its high in early 2002. This weakening
appears to have been caused by some slackening in private investment flows, most likely
responding not only to a desire for diversification but also to (1) slower economic growth in the
United States, (2) interest rate reductions by the Fed, and (3) faster economic growth in the rest of
the world. Additionally, if investors generally expect the dollar to depreciate further, the expected
home currency yield on dollar assets is reduced further, exerting downward pressure on the
currency.
When the dollar begins to fall, particularly after a sharp appreciation, concerns are raised about
whether the process of depreciation could soon devolve into an outright crash, wreaking

¹²^The^Ec^o^nom^is^t^{, Se}^pte^m^be^r¹⁸^{, 2}⁰⁰³^.

devastation on the wider economy. The critical issue is not the dollar per se but the underlying
macroeconomic forces that are propelling it. Again the critical force in this regard is the flow of
international capital into and out of the U.S. economy.
The dollar crash scenario is as follows: We are in a situation where there is widespread agreement
that the dollar needs to depreciate substantially and there is a strong consensus in the financial
markets that the dollar will fall rather than rise. This raises the prospect of a run on the dollar that
leads to a rapid and large depreciation of the dollar that goes far beyond what is needed for the
desired economic adjustment. The fear in some minds is that the move out of dollars could
become a stampede if investors try to flee from dollar assets on a large scale. To shed dollar assets
one needs to find a buyer, but this occurs only through a tremendous bidding down of the price of
the now 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 as lower asset prices translates into
higher effective interest rates. Thus, two sharp negative impulses are transmitted. One, a sharply
falling dollar will likely mean a sharply rising euro and yen, and lead to severe decreases in the
export sales these counties are very dependent on. Two, sharply rising interest rates in the United
States will dampen spending in interest sensitive sectors as well as reveal any lurking weaknesses
in financial markets.
There are, of course, positive impulses associated with a falling dollar: Increased export sales in
the United States and stimulus to interest sensitive sectors abroad. In the dollar crash scenario,
however, the negative impulses have a more immediate effect and are not sufficiently offset soon
enough to prevent recession in the United States, Europe, and Japan.
A disorderly adjustment is possible, but not inevitable.¹³ For one thing, the tendency for interest
rates to rise in this circumstance works to brake the process, as higher yields assuage uneasy
investors. But there is no guarantee that interest rates still would not rise to a dangerously
disruptive level. There are, however, other reasons why a dollar crash is unlikely. First, why run
from the dollar assets if there are no better alternatives? The U.S. economy is still the most
productive and innovative economy in the world, producing more than a quarter of world output
and an even greater share of quality marketable assets. U.S. assets typically offer higher returns
on average then those of Europe or Japan and that return accrues more reliably then higher
yielding assets of emerging economies. Therefore, a reasonable case can be made that it is
unlikely that the rest of the world would easily absorb the net inflow of $700 billion to $800
billion of world saving into the U.S. market, suggesting that, despite some prudent investor
reshuffling of their portfolios, the demand for dollar assets is likely to remain very strong,
assuring that dollar depreciation will likely be orderly.
Second, a substantial portion of the foreign investment in the United States is typically long-term
investment (e.g., direct investment in plant and equipment, long maturity bonds, and stocks),
which tends to be far more stable than short-term portfolio investment flows because it is based
on expectations of long-run return that are less sensitive to adverse short-run changes in economic
conditions and, thereby, highly panic resistant.
Third, as discussed above, China and other emerging economies seem to be strongly tied to an
economic development program propelled by export sales, particularly to the American market.
To maintain the competitive position of their currencies in this market, they will continue to

¹³^Se^e^C^R^S^R^e^por^{t R}^L³³¹⁸⁶^,^I^s^t^h^e^U^.^{S. C}^u^r^r^e^{nt Ac}^c^o^unt^D^e^fic^{it S}^u^s^t^ain^able^?^{, c}^o^or^dⁱ^na^te^d^by^Ma^r^c^La^bonte^.

absorb large stocks of dollar assets, maintaining upward pressure on the dollar. Also, a growing
share of Japanese household saving has become more internationally mobile and likely to be
looking for investment alternatives to typically low yielding domestic Japanese assets.
Fourth, the pool of world saving is likely growing, with substantial new inflows from China,
India, and the oil-exporting countries. Dollar assets will likely be an attractive lure for a large
share of this new saving. This new demand for dollar assets will, therefore, tend to offset some of
the downward pressure on the dollar exchange rate caused by diversification out of dollar assets
by other foreign investors.
Fifth, the dollar is the world economy’s reserve currency of choice. The large size and stability of
the dollar asset markets along with the ongoing needs of international investors for liquidity and a
store of value undergirds the strong persistent international demand for dollar assets. However, a
depreciating dollar over a substantial time period could undermine the dollar’s reserve currency
status.
Predicting the path of the dollar is always difficult. Economic fundamentals predict that the
dollar’s near-term path will broadly reflect the resolution by international investors of an ongoing
balancing of risk and return. Nevertheless, the weight of economic fundamentals on the dollar can
be easily countered in the short-run by sudden shifts in investor sentiment that are imperfectly
understood and difficult to anticipate. Adding to the difficulty at this time are the large dollar
asset holding by foreign central banks that are likely to respond to factors other than calculations
of expected return. What this section of the report will lay out is the probable disposition of forces
that will have the potential to influence the two key investor motives for holding dollar assets: the
incentive to earn a high rate of return, and the need to diversify to minimize the risk of capital
losses from holding too many assets in any particular currency. Considering this array of potential
forces will at least give some overall sense of how the relative probabilities for appreciation
versus depreciation stack up.
In 2007, economic growth in the United States slowed relative to that of other advanced
economies and this relatively slower growth is expected to persist in 2008 and 2009. This
economic performance differential has probably led to a reduction of the expected return on
dollar assets. In addition, the Fed in mid-2007 began to lower short-term interest rates, falling
from 5.25% to 2.0% by mid-2008. However, it appears that the Fed has now ceased lowering
interest rates in the face of rising concerns about inflation. These changes suggest that the foreign
investors, with an already strong need to diversify away from dollar assets, will turn more to
alternatives with more attractive expected rates of return.
In addition, most experts argue that the U.S. current account deficit is too large to be sustainable
and that the real dollar’s exchange rate might have to fall by 20% to 40% beyond the depreciation
that has already occurred to shrink the trade deficit from its current level of 5.3% of GDP to a
sustainable level of about 3% of GDP. Dollar depreciation of that magnitude would further erode
the expected home currency yield of dollar assets, diminishing their attractiveness and increasing
the attractiveness of assets denominated in appreciating currencies.
Whether the central banks of countries that actively use foreign exchange reserves to fix or
stabilize their currencies relative to the dollar will continue to amass dollar reserves on the large
scale seen in recent years probably hinges on the direction of the several market forces just

discussed and on whether China remains committed to maintaining its fixed parity with the dollar.
It may be that China sees the fixed parity as a critical anchor that contributes to the economic
stability needed to attract long-term foreign investment, and sustain the rapid pace of economic
growth needed to continue the still formidable task of absorbing China’s huge labor force into the
industrial sector. If it does, it will accumulate dollar assets as necessary to counter downward
pressure on the dollar relative to the yuan. In general central banks are likely to have longer
investment horizons than private investors and be less sensitive to near-term rate of return
differences between assets in different currencies.
What is difficult to assess is the extent to which liquidity needs, distinct from that of currency
stabilization, will influence the holding of dollar reserves by the Central Bank of China. While
China’s current reserves are large, it is also true that China is under considerable international
political pressure to open up its financial markets and make the yuan a flexible, convertible
currency. A huge stock of foreign exchange reserves may be seen as necessary to make the
passage through this potentially very stormy transition.
It also seems unlikely that the Bank of Japan, the foreign holder with the second largest stock of
dollar assets, would now undertake a large sell-off those assets. If Japan’s central bank were to
dump a large share of its dollar assets on the market, the yen would appreciate, eroding the
competitiveness of Japanese products in the large U.S. market. After nearly a decade of
stagnation, Japan is unlikely to risk derailing its current economic expansion by inducing such a
negative shock to its economy.
In a world awash in dollar assets, many offering only a modest rate-of-return advantage over
alternatives in other hard currencies, and with the looming prospect that at some point a large
deprecation of the dollar will be necessary to correct the United State’s huge current account
imbalance, prudent foreign investors might try to get ahead of impending earnings and capital
losses on their dollar investments that a large dollar depreciation would cause, and diversify out
of dollar assets.
That this sell-off of dollar assets has not occurred so far may speak to the stabilizing effect of
rising official holdings and to the significant liquidity advantage offered by the broad and deep
U.S. financial markets. But it may also indicate a significant degree of investor myopia and the
risk of an all too abrupt clearing of vision down the road. Diversification of assets, however, can
occur without a selling of dollar assets. Investors can merely shift the composition of additions to
their portfolios toward nondollar assets. Also, foreign investors holding a high concentration of
U.S. Treasury securities can manage risk by accumulating other types of dollar assets such as
agency bonds or high-grade corporate bonds that pay a higher yield but offer only a small
increase in risk.

The macroeconomic tools of monetary and fiscal policy have the potential to strongly influence
the value of the dollar exchange rate. In practice, however, these strong policy instruments only
rarely take the dollar as their primary concern. The goals of rapid and stable economic growth,
high employment, and low inflation are usually the principal targets of macroeconomic policy.
The dollar will likely be influenced by such policy actions, and its movement might well support

achieving broader macroeconomic goals; but a particular level for the exchange rate is unlikely to
be an explicit policy goal, and it would be misguided to describe such indirect exchange rate
effects as evidence of an explicit “strong” or “weak” dollar policy.
A major benefit of moving from fixed to floating exchange rates is that it frees the monetary
authority from having to move interest rates to maintain the exchange rate at a fixed value, and
allows it to focus monetary policy on domestic stabilization. Discretionary fiscal policy, to the
extent that it can be used, will exert its effect on the exchange rate through the budget balance.
Whether that balance is a surplus or deficit will be driven by forces largely unconcerned with the
exchange rate.
If the dollar looked as if it were crashing and sharp increases of interest rates were threatened, a
quick policy response would be called for, and would most likely be by the Fed. Such
circumstances could place the Fed in a difficult spot. Stabilizing the exchange rate would dictate
raising interest rates, but that would intensify the pressures faced by domestic interest-sensitive
sectors. Insulating domestic economic activity would dictate lowering interest rates, but that
would intensify the dollar’s depreciation. Most often, domestic stabilization goals can be
expected to take precedent.
The policy task would be easier if fiscal policy could also be used and easier still if other
countries pursued complementary adjustment policies. (Remember, if the dollar is falling, other
currencies must be rising, and that may not be desired, particularly if those other countries are
more dependent on exports to sustain economic activity.) A crashing dollar could be a difficult
policy problem. But, as discussed above, such a crash seems to be a remote possibility.
The dollar may not crash. Nevertheless, most economists argue that the dollar needs to make a
further sizable, but orderly, downward correction. The correction is needed to give relief to
domestic producers of tradable goods and to stem the growth of U.S. net external indebtedness.
How much additional correction will be needed to achieve these goals is open to debate.
Certainly, erasing the trade deficit would require a larger depreciation of the dollar than only
reducing the deficit to a sustainable size. The dollar’s path is highly dependent on decisions in
international capital markets, made by lenders and borrowers alike. Capital markets are capable
of carrying out an orderly adjustment, and such a market initiated adjustment may now be
underway. But economic policy can also influence that adjustment.
The pertinent issue for economic policy is the character of the market forces that are propelling
capital flows. The direction and magnitude of prospective movement of the dollar’s exchange
value will be substantially intertwined with the U.S. economy’s use of sizable inflows of foreign
financial capital to partially finance the economy’s domestic investment spending.
Healthy levels of investment spending undergird long-term prosperity, and it is probably worth
monitoring how well this important activity is proceeding. Because investment spending in the
United States will likely rise with continued economic expansion, and because the level of
domestic saving will likely continue to be smaller than what is needed to finance that investment,
the demand for foreign capital will also grow. This will be a persistent force inclining the dollar
toward appreciation. “Relatively strong” is an ambiguous term: what is being suggested is that the
dollar in this environment may hover well above the level consistent with balanced trade.
Whether this points to some further depreciation from recent highs or a renewal of appreciation is
difficult to judge.

For economic policy to prudently counter United States reliance on foreign capital and push and
hold the dollar at a far lower value, would most likely require an increase in the rate of national
saving. How to achieve a larger flow of domestic saving is problematic. Because the
government’s most direct link to the level of national saving—the state of balance of the federal
budget—is widely projected to be incurring deficits for the next several years, fiscal policy is
assuming a posture that tends to appreciate the dollar. The path of monetary policy is certainly
more flexible and the needs of a slowly recovering economy make it more likely that the Fed will
follow a generally stimulative path in the near-term. This would perhaps be mildly supportive of
depreciation of the dollar. But there is no strong reason to expect monetary policy to exert such
strong downward pressure on the dollar that it would overcome even relatively moderate forces
pushing to appreciate the dollar, such as rising investment spending, larger budget deficits, and
economic weakness abroad.

A “weak” dollar is not necessarily bad and a “strong” dollar is not necessarily good. An accurate
evaluation will depend on what has made the dollar weak or strong. The exchange rate is most
often a symptom of movements of capital between countries. As such, it is these flows, and the
forces behind them, that are likely to shape our final opinion about what is good or bad economic
performance.
A strong dollar that is the result of large capital inflows used to support budget deficits and
consumption, as in the 1980s, may be viewed differently than a strong dollar that is the result of
capital inflows that finance a higher level of investment spending as in the 1990s. The latter,
because it will likely lead to a smaller decrement to our future living standard, seems superior.
Similarly, a dollar that weakens in response to a shift to a higher level of domestic saving may be
viewed differently than a weakening that is the result of investors moving away from a poorly run
economy with few good investment opportunities. The former, because it will mean that more of
the benefit of future growth will accrue to U.S. citizens, seems superior.
The depreciation of the dollar from 2002 through 2004 was most likely due to a prudent response
of investors to concurrent events in the U.S. economy, many of them likely transitory, however.
The modest rise of the dollar in 2005 is most likely the consequence of increased demand for
dollars due to the current and prospective strong performance of the U.S. economy, Fed interest
rate increases, and rising petroleum earnings. Yet, the path of the dollar exchange rate remains
very problematic. The very large accumulation of dollar assets in foreign investment portfolios
likely indicates a continuing need for diversification away from dollar assets. Also, it is difficult
to predict if foreign central banks will continue their high volume official purchases of dollar
assets, but an abrupt change is unlikely. Further, petroleum earnings are likely to remain large and
a sizable proportion will flow into liquid U.S. asset markets. Under the most plausible scenario,
the U.S. economy will continue to use a sizable inflow of foreign capital to help finance its
domestic investment and a seeming glut of foreign saving shows no sign of ebbing. This suggests
that the dollar may continue to depreciate in 2008 and perhaps beyond that. A crash of the dollar
remains a significant risk, but an orderly adjustment seems more likely.

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