Thursday, November 26, 2009

Falling Dollar

For the past decade, the US Dollar has been weak, falling against a basket of currencies. A falling dollar has many implications for both the US and world economy. It is not necessarily a bad thing. A falling dollar, in many ways, is necessary to readjust the global and US economy.

Reasons for Falling Dollar

Persistent US Current account deficit.

Due to a decline in competitiveness and a low domestic saving ratio, the US has been running a current account deficit. Basically, they are buying more imports of goods and services than they export. A current account deficit puts downward pressure on the dollar, especially as capital flows to finance the deficit dry up. Even after a recession and a rise in domestic spending, the US current account deficit remains persistently high (at $500bn). Some economists say a current account deficit is nothing to worry about and reflects the US ability to attract capital. But, there are signs that overseas investors are becoming less willing to buy US assets.

Long Term Changes in Structure of Global Economy.

In the post war period, the US economy was the world's largest and dominant economy. This meant the US dollar was the global reserve currency and used to denominate oil and gold prices. With the rise of China and India, and the Euro, the US economy is becoming relatively smaller. Thus, it is slowly and gradually losing its status as the world's reserve currency, which is pushing down the dollar.

Worries over Debt and Inflation.

The US is certainly not alone in having a rise in public sector debt. However, the recession and financial bailout is pushing US public sector debt towards 100% of GDP. Since the Federal Reserve is also pursuing quantitative easing (creation of dollar) investors are becoming more nervous about dollar assets. They fear, a prolonged policy of increasing money supply could lead to inflation and devalue the dollar.

Low Interest Rates

Low interest rates make it less attractive to save in the US; this should lead to lower demand for dollars and weaken currency. However, because many other countries (such as Eurozone) are experiencing volatility, investors are willing to buy dollar assets, even though interest rates are quite low


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