Dollar Depreciation Issue Analysis

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Table of Contents

Introduction
How depreciation of the dollar influences the economy
Real Trade-Weighted Dollar Exchange Rate
How the depreciating dollar can be strengthened
Conclusion
References

Introduction

The value of the dollar keeps on fluctuating, sometimes it goes up and other times it goes down. The dollar appreciates or depreciates depending on the current prevailing economic factors. For instance, there will be an appreciation of the dollar in the case where there are positive economic factors, for example, a rise in consumer spending. On the other hand, there will be depreciation of the dollar under negative economic conditions such as a recession. Under conditions where there is a rise in the supply of money within the economy, this brings about dollar depreciation. This is for the reason that this supply is going up at a rate that is greater than the demand. The level of the money supply is raised by the government engaging in making more money or issuing out part of the securities it has to get money in return. Thus, moves like these form a basis for dollar depreciation. Moreover, the dollar can also depreciate as a result of the government projecting a slowdown in the economy. Whenever individuals turn out to be jobless, such a situation brings about a reduction in the “disposable income” and in turn, this brings down the level of “consumer spending”. When the unemployment rates are high, this affects the gross domestic product in that it will have to decline. Therefore these factors play a major role in making the dollar depreciate in the course of economic downturns (Carty, 2010). The depreciation of the dollar has several influences on the economy of a country. In this paper, a discussion is going to be carried out about the influence of the depreciation of the dollar on the U.S economy. The depreciation of the dollar decreases the purchasing power of the U.S, causes an increase in the prices of commodities, and brings upward pressure on the interest rates among other effects which may negatively affect the economy. These effects are going to be discussed and possible solutions are going to be considered.

How depreciation of the dollar influences the economy

According to Elwell (2008), “beginning from the break-up of the Bretton Woods international monetary system in 1973, the real exchange rate of the dollar has been largely determined by the market – the supply and demand for dollars in global foreign exchange markets” (Page 2). The demand comes from the foreign people who want dollars to use them to purchase commodities as well as dollar-denominated assets. The supply of dollars is carried out by the American people to the foreign exchange markets and in return, they get those currencies they use to purchase “foreign currency-denominated goods and assets”.

Elwell (2008) points out that, beginning from the year 1994 up to the year 2002 “the real trade-weighted dollar exchange appreciated nearly 30%”(Page 1). There was the occurrence of dollar appreciation although the trade deficit of the United States of America, as well as the foreign debt for this country, went higher in a steady manner. From the year 2002 to date, there has been steady depreciation of the dollar. From the early months of the year 2002 up to the year 2006, the depreciation of the dollar “was moderately paced at about 3 percent to 4 percent each year”(Elwell, 2008). However, in recent times, there has been an acceleration of the fall, going down closely to 10 percent beginning from June the year 2007 up to June the year 2008. Much concern has been arisen by the depreciation of the dollar in five years that have passed regarding the state of the economy of the United States of America. The behavior of the dollar in the times that have passed can be clearly in the graph below:

Real Trade-Weighted Dollar Exchange Rate

The depreciation of the dollar brings about the increase in prices of the foreign goods and this, in turn, brings down the level of the purchasing power of the consumers in the United States of America as well as the businesses in the US to buy imports. According to Elwell (2008), from the beginning of the year 2002 up to the year 2007, the imports price index rose by about 32 percent in comparison with a rise in the “price index for overall GDP” by approximately 16 percent. The 32 percent increase in the imports price index gives a reflection of the impact of the weakening dollar as well as the increases in the “average price of foreign currency price of imports”( Elwell, 2008 page 8).

In the years that have just passed, there has been a sharp increase in the prices of imported goods in the United States of America. However, since many of the commodities are assigned prices in terms of dollars, the increasing prices are not a direct product of a depreciating dollar. Elwell (2008) observes that there is the likelihood that the falling value of the dollar has had a raising effect on the prices of commodities indirectly. He points out that, “an appreciating dollar currency serves to insulate the economy from such price increases, while a depreciating currency will tend to exacerbate their effect” (Page 13).

The level of the effect of the depreciating dollar on the general purchasing power of the country is subdued by some factors. One of the factors is that an increase in the export prices is inclined to boost the “purchasing power” and make up for the “increased import prices purchasing power effect”. Based on this, the experts in the field of economics make use of the shift in the ratio of “export prices” to “import prices” to carry out the calculation of the change in the international purchasing power of the United States of America (Fan, 2002).

According to Elwell (2008), the main driving force for the depreciation of the dollar from the year 2002 has been deteriorating dollar-dominated assets demand by the private investors. “A significant slowing of this capital inflow, other things constant, reduces the supply of loanable funds available for the economy and tends to increase the price of those funds (increase interest rates)” (Elwell, 2008, Pg 9). Beginning from the year 2004 all through to the year 2006, a reduction in the demand for the dollar assets is likely to have made a large contribution to the increase in the interest rates in the United States of America. In case the foreign dollar assets demand goes on to grow weak while the economy of the United States goes beyond the present economic slowdown and starts at a more characteristic rate, there is a likelihood of the recharged demand for loanable finances to bring about a rise in most of United States interest rates. The effects of a declining capital inflow and a depreciating dollar and the increasing interest rate could operate to alter the output composition of the economy, boosting the net exports and bringing down the level of domestic spending by dampening those activities that are sensitive to the interest rates. Such interest-sensitive activities are such activities as housing and business investment. Increasing interest rates are the common balancing means which align domestic investment with saving flow which is there to fund it (Stewart, 2006).

In case there is a rise in the rate of domestic saving to take up some part of the reduced inflow of saving from foreign countries, there is a likelihood that this will carry out the moderation of the increase in the rates of interest and bring about a change of the decrease in domestic spending “from investment to consumption” (Elwell, 2008, Pg 11).

How the depreciating dollar can be strengthened

Several policies can be put in place to strengthen the depreciating dollar. One of the measures that can be taken is “Foreign exchange market intervention”. To strengthen the dollar, the Federal government may decide to promote the demand for the dollar. This can be carried out by selling some of the “foreign exchange reserves” it has to obtain back dollars.

Another instrument that can be used is the monetary policy. This is defined as “the decision by policymakers to influence economic conditions by tightening or loosening credit conditions” (Bofinger, 2001, Pg 71). In considering monetary tightening, this will enhance a rise in the interest rates. On the other hand, monetary loosening will enhance a reduction in interest rates. Carrying out the alteration of the interest rate level will as well alter the exchange rate for the dollar. There is a tendency for the “contractionary monetary policy” to make the dollar stronger for the reason that the higher interest rates, promote dollar demand in the market for foreign exchange. This is realized by making the dollar assets to be more attractive to investors from foreign countries. On the other hand, an “expansionary monetary policy” tends to make the dollar weak for the reason that the interest rates that are lower bring down the level of attractiveness of the dollar assets.

Another policy instrument is the fiscal policy. By the government choosing tax or spend, this can as well bring influence on the exchange rate. There is a tendency for the budget deficits to have “a stimulative effect” on the economy of a country. Yet, since the government has to engage in borrowing to clear the budget deficit, there is a tendency of this policy to as well bring up the level of the interest rates. Holding other things constant, the higher interest rates shall tend to bring up the level of the foreign demand for the dollar-denominated assets, exerting pressure (upward pressure) on the rate of exchange (Hansen, 2003)…

The dollar could also be strengthened by putting in policies that are focused on bringing up the level of the demand for the goods as well as services of the United States. One of such policies is having “lower foreign trade barriers”. The ongoing existence of several trade barriers in several nations may weaken the demand for the exports of the US to even a higher extent than it is supposed to be. In case bringing down the level of such barriers would play a significant role in promoting the demand for the U.S exports, then such a move would also play a role in imposing pressure (upward) on the exchange rate for the dollar. However, it is hard to carry out judgment about the level of this kind of pressure. In addition, there is a low likelihood for this policy instrument to be put in practice and possibly it has very minimal near-term importance for the exchange rate of the dollar.

Another measure that could be taken is “support for the development of new products”. In the case where the U.S can have those commodities as well as services that have a high demand from other parts of the world, this will trigger upward pressure on the dollar exchange rate. A policy like this would have a high likelihood of having implications that are long-term, and will not have a great effect on the “near-term” dollar value.

Conclusion

The depreciating dollar influences the economy of the United States of America in several ways. Some of the effects that have been looked at are increasing commodity prices, reduced purchasing power, and upward pressure on the rates of interest. These effects bring some negative implications which need to be done away with. Among the measures that need to be put in place to handle this issue is to implement some appropriate policies. Among the policies to be implemented are the monetary policy, fiscal policy, and “foreign exchange intervention” among others.

References

Bofinger, P., et al. (2001), Monetary policy: goals, institutions, strategies, and instruments. New York: Oxford University Press.

Carty, L. S., (2010). What causes the depreciation of the dollar? Web.

Elwell, C. K., (2008), The depreciating dollar: Economic effects and policy response. CRS Report for Congress. Congressional Research service.

Fan, E. X. (2002). Implications of a U.S dollar depreciation for Asian developing countries. ERD Policy Brief, No. 11.

Hansen, B. (2003). The economic theory of fiscal policy. New York: Routledge.

Stewart, D. (2006) Bankrupt your student loan: And other discharge strategies. New York: Authorhouse.

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