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This link is to a publication by the Federal Reserve Bank of Chicago called ⎯ Strong Dollar Weak Dollar. It is a primer on exchange values.

Difference of Opinion

When is the value of the dollar just right?

Answer: President Reagan liked a strong dollar. Later, Secretary Baker began policies to lower the dollar because it was too high.  President George W. Bush said his administration liked the strong dollar he inherited, but he would not interfere with its value. The dollar fell or was allowed to fall later in his term. There is no value that is unconditionally or always right. When the value of a currency “appears” to be causing problems (trade imbalances, inflation, job losses), then the injured parties will often decry that the value of the dollar needs fixing. They will proclaim it a national problem. In 1995 when the dollar was very weak many people felt it was much too low and was causing important problems for the country. In 2000 many people felt the dollar was too strong and was causing problems for the country.

A good value of the dollar, it would seem, would be a value that would erase the trade deficit. But what if achieving that lower value of the dollar comes at the expense of high inflation or it hurts companies that rely heavily on imports? Thus, the nominal value of the dollar might be low – but the real value could be much higher. Clearly, when one refers to good dollar value they are referring to a real exchange rate. Clearly the issue of the best dollar value is multidimensional and controversial.

What determines the value of a currency?

Answer: A lot of things – and to understand this better we will develop a supply and demand model that focuses on exchange rate determination.

Economists use supply and demand to explain many different things. In macro we often use AS and AD to think about prices and real GDP. We can also use labor demand and supply to discuss the nation’s wage rates and employment levels. In microeconomics we discuss the supply and demand for steel as a way of understanding changes in the price and output of steel.

Here we use the supply and demand for international traded currencies to discuss the value of a currency. We use the dollar in our example, but we could have equally used any currency. We simplify the analysis by assuming only two countries – the U.S. and the rest of the world. What we are describing here might be called a foreign exchange (FEX) market.

The interaction of the supply of internationally-trade dollars and the demand for internationally trade dollars will determine the value (price) and quantity of dollars traded.

Before we get to the details of the analysis it helps to create a mental picture of the FEX market. Who uses it? That is, who wants to trade currencies? In our example, who wants to buy and sell dollars in exchange for other currencies? The answer is – people who want to do international trade. Whether a foreigner wants to buy a U.S. toaster or a share of IBM stock, he or she has to buy dollars. When a U.S. citizen wants to travel on Lufthansa or buy a radio made in China, he or she has to sell dollars and buy euros or renminbi.  

Speculators also participate in FEX markets – buying currencies they hope will rise in price and selling those they think will fall. Finally, governments and central banks participate in these markets too. The make international loans and pay them back. They may also buy goods and services internationally. But our main focus on governments is how they buy and sell currency to “peg” or influence exchange values.

With that background we can define some things.

  • The supply of dollars traded in FEX markets is primarily determined by people who have dollars (mostly U.S. citizens) who want to purchase foreign goods, services, and assets. You and I might not directly sell these currencies – very often banks or other financial institutions quietly act as our go-betweens. It may also be affected by speculators who think the value of the dollar is going to change in the future. If they think the exchange rate is going to fall later, they may sell more dollars today. Governments may sell dollars as a way to prevent the value of the dollar from rising – or to push its value lower.
  • The demand for dollars traded is largely determined by people who want to buy U.S. goods, services, and assets. Speculators may want to buy more dollars if they think the value is temporarily low. Governments will demand more dollars if they want to raise the value of the dollar.
  • Equilibrium values of the dollar and the volume of dollars traded are determined by the interactions of supply and demand for internationally traded dollars.

The following diagram brings together these supply and demand concepts into a model of exchange rate determination:

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What causes the value of the dollar to increase or decrease?

Answer: Using our supply and demand FEX analysis we can say that anything that might cause the demand for dollars to rise or the supply of dollars to fall would put cause the equilibrium value of the dollar to rise. Note: This market behaves like any market. If the supply of steel declines or the demand for steel rises – we would predict a rise in the price of steel. 

Consider some of the usual causes of change in the FEX market. What might cause dollar demand to fall and dollar supply to rise? The main answer is – anything that makes people want to more, services or assets abroad and fewer goods, services, and assets in the U.S. Imagine all the things that might cause a redirection of buying away from the U.S. and towards the rest of the world. Here is an incomplete list of such things –

  • Less confidence in the U.S. economy relative to the rest of the world,
  • more competitive pricing of goods in other countries.,
  • poor productivity growth  that leads to higher unit costs and prices in the U.S.,
  • interest rates in the U.S. fall relative to rates in other countries, and
  • U.S. product innovation fails to create new goods or services that are more widely available abroad.

In the FRBSF Economic Letter (November 17, 2006, Interest Rates, Carry Trades, and Exchange Rate Movements”), Michele Cavallo notes there were great swings in the value of the dollar in 2005 and 2006 and he concludes, “Many observers have related these swings to carry trade. This is a strategy widely used by investors in international finance markets that is based on exploiting the existence of interest rate differentials across countries.” For example, when US interest rates started rising relative to Japanese rates, it created an opportunity for investors to borrow money in yen and invest it in dollars. This had the effect of causing the dollar to rise relative to the yen. Whenever interest rate differentials change, there is a tendency for this carry trade to have impacts on exchange rates.

Less usual but possible causes of changes in the value of the dollar are speculators and government behaviors. If speculators believe any of the above things might cause, for example, the value of the dollar to fall in the future, then that presents a dollar-selling opportunity today. They would unload (sell) lots of dollars as they purchased more yen, euros, and other currencies.  If governments wanted the value of the dollar to fall as a matter of policy, then governments could sell more dollars. Governments that sell dollars will be increasing their stocks of foreign currencies. At another time they would sell those stocks (buy dollars) as a means to raise the value of the dollar.

To think about what might cause the value of the dollar to rise or appreciate – just reverse the arguments above. Keep in mind the central point. The dollar will fall in value when the world is selling dollars and buying more pesos, Australian dollars, euros, and other currencies. They will do this when they see better products and buying opportunities outside of the U.S.

What caused the value of the dollar to rise so much in the late 1990s? And then to fall in 2002?

To answer this question we refer you to two readings:

“Is the Large U.S. Current Account Deficit Sustainable? By Jill A. Holman,

Economic Review of the Federal Reserve Bank of Kansas City (1st Quarter, 2001), pp5-23

Article was originally taken from

“A Perspective on U/S. International Capital Flows,” by William Poole, Economic Review of the Federal Reserve Bank of St. Louis, January/February, 2004, pages 1-8. This article can be located at:

Answer: The basic story is that two key factors explained a rising value of the dollar in the late 1990s: productivity and wealth. Prospects of higher productivity in the U.S. sent firms rushing into faster investment purchases. Plant and equipment spending soared. This increase of investment over saving led to a larger margin of U.S. interest rates over foreign rates. The U.S. bond and stock markets were seen as a great place to invest. As a result there was a great demand for U.S. dollars. This drove the value of the dollar upward.  In the late 1990s, the U.S. stock market soared and made a lot of people feel richer. These people spent some of their new found wealth. U.S. consumers increased their spending for both domestic and imported goods and services. Thus, the supply of dollars was increasing and putting downward pressure on the dollar. This downward pressure was, apparently, less than the upward pressure coming from the capital inflow and the net result of these two key forces was a higher dollar.

The following diagram shows the impact of increased demand for U.S. capital on the dollar:

Screen Shot 2016-04-24 at 4.13.00 PM

Below we see the falling dollar as a result of U.S. citizens wanting to buy more foreign goods and services:

Screen Shot 2016-04-24 at 4.13.05 PM

The reversal of these two factors explains much of the decline in the value of the dollar since then. Productivity growth in the U.S. remained strong through 2004, but not as strong as it had been in the late 1990s. Thus the U.S. productivity differential narrowed. The decline in the U.S. stock market reduced wealth but it didn’t put much of a crimp in the desire for imports. It did, however, cause foreigners to think twice about their U.S. investments. While the changes were quite orderly, the truth is that capital exports (inflows) declined relative to the late 1990s. The net result of these changes was to reduce the demand for dollars and increase their supply, pushing the dollar down. (This story oversimplifies and leaves out many other things that might have been impacting the value of the dollar negatively in those turbulent times after 9/11 and the War in Iraq.)

What is the conventional wisdom about dollar policy?

Answer: While the dollar had come down somewhat from previous highs, the U.S. was left with a very large trade deficit in 2004. Dollar policy essentially means pushing the value of the dollar down so as to make U.S. goods globally competitive enough to significantly remove the trade deficit. This policy could be accomplished in one of two ways. First, the Treasury/Fed would sell more dollars on the FEX markets. Second, the Fed could use domestic open market purchases to push U.S. interest rates down. As interest rates fell, foreign demand for U.S. assets would fall. People would sell dollars as they moved away from U.S. assets. 

Do conservatives approve of the conventional wisdom?

Answer: No and for several reasons.

  • First, we would be aiming at the wrong target. Saving and investment determine the trade deficit, not the dollar. The dollar is a symptom, not a cause, of the trade deficit.
  • Second, a depreciating dollar means higher imported inflation. Notice that a dollar depreciation policy is tantamount to increasing the domestic money supply and increasing both domestic and foreign sources of aggregate demand.  
  • Third, the trade deficit is partly the result of strong U.S. economic growth relative to growth of its main trading partners. When the U.S. economy grows fast, it buys more goods from abroad. When the trading partners are growing slowly, they buy less from the U.S. The exchange rate changes will not fundamentally affect these differential growth rates. What is needed is for convergence in growth rates.
  • Fourth, speculators can and often do spoil the party. This is an easy story. Let’s suppose the U.S. government does manage to peg the value of the currency at a lower value. What are speculators going to do if they believe that fundamental factors are going to increase dollar demand in the future? That’s right – speculators will attempt to buy more dollars – they see this as a great opportunity—the government has created a great buy-opportunity from them. As they buy more dollars they force the value up again.
  • Lesson – if the government pegs the value of a currency below the fundamental value, their pegging will fail.   

The first of the next two diagrams shows how governments can sell dollars as a means to pressure the dollar downward. The second one shows how the practice might fail if speculators believe that the government’s policy won’t succeed:

Screen Shot 2016-04-24 at 4.13.12 PM

Screen Shot 2016-04-24 at 4.13.18 PM
Do liberals approve of the conventional wisdom?

Answer: They don’t agree either – but for different reasons. Journalist Robert Kuttner thinks that other countries don’t play fair. Markets are closed. What does price matter if markets are closed?  Kuttner also believes that dollar depreciation is tantamount to a reduction in the relative wages of U.S. workers since it means that a given wage would buy less imported goods. Of course, if the dollar devaluation leads to higher inflation, then workers’ domestic buying power would be falling too. With this last argument Kuttner would be agreeing with the conservatives. While Kuttner tells interesting stories, it isn’t clear how much unfair competition really stops U.S. goods from finding their ways to foreign ports – and very few economists cite protectionism as an important reason for U.S. trade deficits.

Even more difficult is what you do about it if protectionism does have a non-negligible impact on trade. Some people believe it is then proper to retaliate – so protectionism begets protectionism. Surely that compounds the problem without making it better. It should be recognized that many countries, including the U.S. and countries in Europe, have a long tradition of protectionism that is not easy for any domestic politician to change. If the U.S. threatens to retaliate against another country, it is unlikely that the threat is large enough to overturn their local politics. It works both ways. When Europe gets cranky about U.S. subsidies to its farmers, they know there is a small possibility that the U.S. will quickly remove a long-standing policy.

International Application: China and Other Countries Peg Their Currencies to the Dollar

Many countries in the world like to peg their currency value to the dollar. Some fix it exactly while some allow for a band around a mean value (a dirty float). Some countries have what’s called a currency board that comes close to fixing its currency value. Estonia fixed its kroon to the German d. mark and then the euro. Some countries stop using their own currency and replace it with dollars – this is called dollarisation.

Why do counties do these kinds of things? Why do we care? We care because we want to forecast future exchange values. You would think this would be very easy since the exchange rates are largely fixed. But it isn’t because these systems often don’t last. That is, the date of the end of the system is a random variable. If one can predict the end of one of these fixed exchange rate systems – then one can make a lot of money – or at least prevent losing a lot.

Why don’t they just let their currencies float? Probably the main reason many countries don’t want their currencies to float is because they are worried about them depreciating. Developing or transforming nations have large needs for foreign investment. But a decline in the value of their currency is anathema to inbound foreign investment. If a U.S. citizen, for example, invests money in a country and then its currency depreciates, any returns or profits he or she would earn would turn into fewer dollars. So many countries peg their currencies so they won’t depreciate.

Note: there are other reasons why countries don’t like depreciated currencies. For example, a country with an inflationary past may want to signal in a strong way that it is determined to stop inflation. A low value of the currency also makes imports more expensive. If a country relies on imports of key materials and equipment, then it might prefer a stronger currency.

But sometimes they just can’t keep up the peg. Why? Because something happens that makes the world have less confidence in this country. The government might have larger fiscal deficits that become very difficult to pay back. Maybe the government has a scandal. Maybe the new government isn’t trustworthy. Whatever the case may be – if world investors withdraw their funds, the currency will depreciate. The country can try to stop this by using their foreign reserves to buy their own currency in FEX markets – but they usually have limited foreign reserves and once they start to dwindle, the problem gets even worse. So people watch these foreign countries with exchange rate pegs like hawks watch rabbits in the field. As soon as a country shows signs of weakening, the chances of the peg failing starts to increase. Mexico had problems in 1994. After failing to hold their peg against the dollar, they abandoned it. A similar experience befell several Asian countries in the 1997 currency crisis with currency attacks on Thailand, Malaysia, Indonesia, and South Korea and then spreading to Brazil. Argentina went through that process at the end of 2001.

China is a very interesting case. China has for some time pegged its renminbi at about 8.27 to the dollar. But unlike the motivation of most countries, China is worried about its currency rising too much—they do not seem to be worried about it depreciating. Why? Because China has a lot of confidence in the staying power of its inbound foreign investment. Also China has not experienced large persistent trade deficits and relies very strongly on the power of its exports. China had foreign exchange reserves of about $1 trillion in 2006. It wants to keep its currency from rising because it wants to keep its exports very strong. But even China’s peg could fail and currency traders and the rest of us keenly watch for signs of a crack that would cause its currency to appreciate. In the middle of 2005 it announced a change in the form of its pegging. At the end of 2006, the dollar/renminbi had fallen to 7.844, implying a depreciation of the dollar of a little less than 10% in the course of a year and a half. Europe and much of the world would like to see China’s currency appreciate. Europe competes with China – and while the euro has risen considerably against the dollar, the renminbi hasn’t. This puts European exporters at a disadvantage. Some U.S. voices also consider this pegging to be a form of protectionism – or what some economists refer to as an unfair “beggar they neighbor” policy. When China was a poor developing country, this unfairness seemed permissible. But now that it has grown and is now a member of the World Trade Organization, there is less sympathy. So there is much pressure on China to let its currency either float or to at least peg it at a higher value. When or if this will happen is something that planners will pay attention to.

Industry Application

What is the future course of the value of the dollar?

We can’t answer any questions about the future with certainty, but we can bring together what we consider to be the relevant facts to discuss a likely outcome. Here is an assessment we made in early 2005 about the dollar value in 2005 – explaining why the dollar would rise by 10%. You are reading this after 2005, how did we do? Where were we wrong?

  • A large looming factor for 2005 is what happens to oil prices. This could amount to a supply shock large enough to create some real change.
  • It is likely that other countries – especially places like India and China, will be more negatively impacted than the U.S.
  • If so, the U.S. trade deficit will worsen because the U.S. will continue buying from foreign countries but the latter will reduce their U.S. purchases. This would put downward pressure on the dollar.
  • With the U.S. relatively less harmed by the oil shocks, the U.S. stock and bond markets will attract considerable foreign buyers. This will put upward pressure on the dollar that will swamp the downward pressure mentioned above.
  • Additionally, energy sensitive countries will encounter higher inflation increases than those of the U.S. This will add to the value of the dollar rising. Some countries will tighten monetary policy significantly and raise interest rates. That will push the value of the dollar downward. But much depends on confidence. If the rising interest rates push these countries into deep recessions, then risk adjusted rates of return in those countries will fall. Money will flow to the U.S. and the dollar will rise.

International trade and exchange rates will continue to be among the most important global macro indicators of the future business environment. There is a lot to master to stay on top of the subject – but it should be worth the effort. Bon Voyage!