As we know, the value of the dollar depends on what determines the supply curve and demand curve on the foreign exchange markets, which obviously is linked to supply and demand for the underlying transactions (be sure not to get confused by the chicken and egg problem). By clealy identifying these transactions, who are the winners, who are the loosers, we can better evaluate the net impact, if any, on the overall economy.
NET IMPACT ON THE ECONOMY OF THE FALLING DOLLAR
The transactions that lead to the falling dollar include rampant government borrowing, furious consumer spending and a current-account deficit big enough to have bankrupted any other country some time ago. This makes dollar devaluation inevitable, not least because it becomes a seemingly attractive option for the leaders of a heavily indebted America. Policymakers now seem to be talking the dollar down. Yet this is a dangerous game. Why would anybody want to invest in a currency that will almost certainly depreciate?
The transactions that lead to the falling dollar have hit the global financial system is that it has become a giant money press as America's easy-money policy has spilled beyond its borders. Total global liquidity is growing faster in real terms than ever before. Emerging economies that try to fix their currencies against the dollar, notably in Asia, have been forced to amplify the Fed's super-loose monetary policy: when central banks buy dollars to hold down their currencies, they print local money to do so. This gush of global liquidity has not pushed up inflation. Instead it has flowed into share prices and houses around the world, inflating a series of asset-price bubbles.
America's current-account deficit is at the heart of these global concerns. The OECD's latest Economic Outlook predicts that the deficit will rise to $825 billion by 2006 (6.4% of America's GDP) assuming unchanged exchange rates. Optimists argue that foreigners will keep financing the deficit because American assets offer high returns and a haven from risk. The transactions that lead to the falling dollar have induced private investors to turn away from dollar assets: the returns on investments in America have recently been lower than in Europe or Japan
In a free market, without the massive support of Asian central banks, the dollar would be far weaker. In any case, such support has its limits, and the dollar now seems likely to fall further. Conceivably, it could happen-but such a one-sided remedy would most likely be far more painful than they imagine. America's challenge is not just to reduce its current-account deficit to a level, which foreigners are happy to finance by buying more dollar assets, but also to persuade existing foreign creditors to hang on to their vast stock of dollar assets, estimated at almost $11 trillion. A fall in the dollar sufficient to close the current-account deficit might destroy its safe-haven status. If the dollar falls by another 30%, as some predict, it would amount to the biggest default in history: not a conventional default on debt service, but default by stealth, wiping trillions off the value of foreigners' dollar assets.
The dollar's loss of reserve-currency status would lead America's creditors to start cashing those checks. As that process gathered pace, the dollar could tumble further and further. American bond yields (long-term interest rates) would soar, quite likely causing a deep recession. Americans who favor a weak dollar should be careful what they wish for. Cutting the budget deficit looks cheap at the price.
It is the new consensus view in America that the dollar has to bear the brunt of reducing the U.S. current account deficit. Clearly, American policymakers want a lower dollar, apparently entertaining strong hopes that this will take care of the U.S. trade deficit, and it is suspect that they regard it as an easy solution for this problem.
The transactions that lead to the falling dollar essentially presuppose that an overvalued dollar is the main cause of the U.S. trade deficit. This is bogus. By the measure of purchasing power, the dollar was hardly out of line with the currencies of other industrialized countries.
The favorite American explanation for the huge and growing trade deficit is the U.S. economy's superior growth performance and lacking foreign demand. But the Chinese economy is growing much faster than the U.S. economy yet has a big trade surplus. So had Japan in the late 1980s, and so had Germany in the decades to the late 1970s.
This explanation of the trade deficit with superior U.S. GDP growth is ...
Depict and assess the value of the dollar.