What is the "dollar"?
"The dollar" actually refers to the exchange rate of the dollar. It is the price of the dollar that people in other countries have to pay for it.
What do exchange rates do?
Once the price is set, a currency can be traded. Trading occurs in foreign exchange markets, which are essentially large transactions between big firms and large banks.
Which exchange rate is correct?
The exchange rate can be expressed in numerous currencies. All of them are correct, but there are two measures that are of particular importance. First, there is the dollar's exchange rate against the euro. This exchange rate has dropped sharply, so that foreigners have to pay less than they did before to buy dollars. Second, the Federal Reserve created a measure – the real broad index – that reflects the price changes of all important currencies against the dollar and that corrects for inflation rate differences between the U.S. and other countries. This is the most comprehensive exchange rate measure.
How much has the dollar changed?
An understanding of history helps to answer this question. In the early 1980s, the dollar rose to record highs. Foreigners had to pay more than ever before to purchase dollars. Starting in 1985, the dollar declined until 1995. It then rose again until early 2002, before falling once more starting in February 2002. Since then, the dollar has lost close to 15 percent of its value, as measured by the Fed's real broad index. At the same time, though, the price of the dollar expressed in euros fell almost twice as much.
How are exchange rates determined?
Exchange rates are determined in foreign exchange markets. These exist because banks buy and sell foreign currencies from each other in large quantities and at enormous speed. A market, however, only exists for currencies that can actually be bought and sold. These currencies are called convertible currencies. When foreign exchange markets can determine the price of a currency without government interference, a currency is said to be "floating," such as the dollar. Some countries, though, intervene in the market to move the price of a currency in one direction or another by buying or selling a currency. This process is called "dirty float" or "managed float," such as Japanese yen. Some governments place formal restrictions on the sale and purchase of their currencies. These types of limits are called capital controls. With capital controls in place, a country's government, such as China, can set the price of the currency without having to deal with fluctuations in the foreign exchange market. These are called fixed exchange rates.
Why does the euro get so much attention?
The euro is a fairly new currency for a relatively important economic area. It replaced a number of European currencies starting in 2000. Not all, but most European countries participate in the euro. With the introduction of the euro, the dollar has gained an important rival. The concern is that the euro will become a real competitor and that foreign investors will bring their money to Europe, rather than to the U.S.
Why do exchange rates matter?
To purchase something in another country, one has to pay for it in that country's currency. To buy a computer in Japan requires yen. Americans thus need to go to a bank and convert their dollars into yen to pay for their purchase. When the price of the dollar falls, it takes more dollars to make the same purchase overseas as before. The process works the other way around for foreigners. When the price of the dollar falls, it becomes less expensive for Japanese to buy American goods.
How is the exchange rate linked to the trade deficit?
All purchases of U.S.-made products and services by foreigners are considered exports and all purchases by Americans of products and services made overseas are considered imports. The difference between exports and imports is the U.S. trade balance. The prices of exports and imports depend on the dollar exchange rate. If the price of the dollar is high, it is easy to buy stuff overseas, but it is hard to sell U.S. products in other countries. As a result, exports are low and imports are high, and the U.S. has a trade deficit.
What is the connection between the dollar and capital flows?
With a trade deficit, money leaves the country and goods come in. Since the U.S. does not print yen, pounds or euros, it needs to borrow them overseas to pay for the extra imports. Foreigners hence have to lend money to the U.S. when it has a trade deficit.
Where does the U.S. get money to pay for its trade deficit?
Although many people from a vast range of countries lend to the U.S., a few lenders play a bigger role than others. In particular, governments in Asia have been playing a large role in financing the U.S. trade deficit. These include Japan, China and Korea.
Where does the money from foreigners go in the U.S.?
Saying foreigners lend money to "the U.S." is shorthand for money moving from overseas to investments in the U.S. Some of the money goes into stocks, some goes to finance bond issues by U.S. firms, part of the money finances brick and mortar operations, such as car manufacturers, and some to the U.S. government. From 2001 to 2004, foreigners have financed 80 percent of the federal government deficit.
Why do foreigners lend to the U.S.?
Foreigners lend to the U.S. because they believe it is a good investment. The U.S. is a good investment if it grows faster than other countries. It is also a good investment if U.S. interest rates are higher than those in other countries. Finally, investors may consider the U.S. a good investment if the value of the dollar rises, as was the case in the late 1990s. A higher price for the dollar means that foreigners can get more money in their own currency when they return the money they lent to the U.S. back to their own country.
What is the problem anyway?
The U.S. relies on foreign capital to keep its economy going. The government and families are borrowing money to make ends meet. The additional money comes from overseas. More money flowing to the U.S. keeps the price of the dollar high. This makes U.S. exports more expensive, imports cheaper, raises the trade deficit, and requires more loans from overseas investors.
Would a lower dollar help the U.S.?
A lower value of the dollar is good for those who want to sell products abroad, but it is paid for by those who depend on importing products and services from overseas. A lower dollar is also bad for people who lent their money to the U.S. Their investments are worth less than they were before the decline.
Why does it matter if the U.S. gets less money from overseas?
At some point, foreigners may not be willing to continue lending money to the U.S. if they lose money on those deals. If the price of their investments – the exchange rate – keeps falling, they may take their money elsewhere or ask for higher interest rates to keep it in the U.S. This could lead to lower growth and higher unemployment.
Why does fiscal discipline matter for the dollar?
If the federal government shows restraint and reduces its deficits, it will have to borrow less from foreigners. This lowers demand for dollars and the exchange rate goes down. A lower exchange rate could help exporters to sell their products overseas.
What can China do to improve the situation?
Another way to solve the U.S. dependence on foreign capital is to reduce the U.S. trade deficit. One of the largest U.S. trade deficits is with China. China fixes its exchange rate at a level at which it is more attractive for Americans to buy Chinese products than it is for Chinese to purchase U.S. products. The Chinese government could raise the value of its currency, thus lowering the price of the dollar for Chinese consumers. This would make it more attractive for Chinese to buy American products, increasing U.S. exports to China.
What is the impact of a dollar decline for the average American?
Imports become more expensive and exports become cheaper, lowering the trade deficit and creating U.S. jobs. This is easier said than done. Switching from imports to domestic production takes time. Importers have already promised to buy products from foreigners, and U.S. manufacturers will need some time before they can meet the additional demand. So, for a while Americans are still buying the same amount of goods, but at higher prices. After some time, the shift from imports to domestic production will be made and workers will benefit from more jobs. In the meantime, the U.S. still has a trade deficit. Thus, the U.S. has to borrow money overseas, even though a declining dollar also means that the value of investments in the U.S. falls. If all of the changes happen gradually, the threat of higher interest rates from inflation and from fewer capital inflows may be small.
Is there a progressive policy to deal with the dollar?
Policymakers have to find a fine balance. The challenge is to allow the dollar to decline, while lowering the need of the U.S. to borrow money overseas. Reducing government deficits would lower the dependence on foreign capital. Public policy could also encourage families to save more. More incentives for middle-class families to save can help to reduce the dependence on foreign capital. Further, the government should engage in diplomatic efforts with countries in which the dollar exchange rate has declined very little or not at all to get them to increase the value of their currencies against the dollar. This would be especially important in the U.S. relationship with China.
Christian E. Weller is senior economist at the Center for American Progress.
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Christian E. Weller