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1 1 (February 6, 2023)

handle is hein.crs/goveklt0001 and id is 1 raw text is: informing ~ssona IRFesedrch Service I hec e latived dhats sne1914 February 6, 2023 Strong Dollar: Implications for U.S. Economy Over the past decade the U.S. dollar has generally increased in value relative to other currencies, reaching new heights since the beginning of the current economic expansion. This appreciation resulted from domestic and international economic conditions but also directly affects the U.S. economy, notably in its effect on trade. This In Focus discusses the recent strengthening of the dollar, potential causes and effects, and policy implications. Recent Trends To determine the value of the dollar, economists compare it to other currencies. These comparisons are known as exchange rates and measure how much of one currency a unit of another currency can purchase. To consider how the value of the dollar has changed over time in relation to multiple currencies, the Federal Reserve produces a number of indexes. One such measure, the broad dollar index, is shown in Figure 1. The Fed calculates the broad dollar index using the currencies of major U.S. trading partners (based on volume of bilateral trade). Based on this measure, in both real (inflation-adjusted) and nominal (unadjusted) terms the value of the dollar has been trending generally upwards (appreciating) since 2011, peaking in October of 2022 and falling slightly (depreciating) since then. The broad dollar index only provides data back to 2006. Using information from discontinued trade-weighted dollar indexes, this episode is the third time since the United States adopted a floating exchange rate regime in the 1970s that the dollar has undergone extended periods of significant appreciation-it also happened in the first half of the 1980s and again in the second half of the 1990s to the early 2000s. Causes of the Strong Dollar Since the fixed exchange rate regime ended in the 1970s, the value of the dollar has been determined largely by the forces of supply and demand in foreign exchange markets. Participants in these markets-which include a variety of private investors, investment firms, private banks, and central banks, among others-can buy, sell, and exchange currencies, which allows for international trade of goods and services, foreign investments, and other cross-border financial transactions. Factors that have contributed to the dollar appreciation over the past decade include increases in foreign investors' net savings, relative increases in U.S. interest rates, and increasing demand for U.S. assets. Most recently, dollar appreciation has been a result of economic conditions and policy surrounding the COVID-19 pandemic. The pandemic spread globally in early 2020 and caused deep disruption to the U.S. and foreign economies and financial markets. Such a global crisis tends to result in a flight to safety, whereby investors flock to the dollar, causing it to appreciate. This is what happened in early 2020. As financial markets normalized, the dollar depreciated somewhat. After a brief period of depreciation, the dollar again began to appreciate in 2021 and continued to do so throughout most of 2022. A number of factors may have contributed to the appreciation since 2021, including the relative speed of economic recoveries, relative interest rate levels, and investor demand for U.S. assets. A prominent reason for the appreciation in 2022 has been relatively fast-paced interest rate increases in the United States compared to other countries. In response to inflation, which began to rise in 2021, the Federal Reserve has been increasing its policy rate fairly aggressively, causing other interest rates in the economy to rise as well. Figure I. Broad Dollar Index January 2006 to January 2023 Source: Federal Reserve H. 10 Foreign Exchange Rates. Higher interest rates in the U.S. economy relative to foreign economies make U.S. assets more attractive relative to foreign assets, causing investors to demand dollars to invest in U.S. assets and the dollar to appreciate. For the dollar to remain strong, foreigners must be willing to continue to invest in U.S. assets despite the U.S. negative net international investment position (NJJP, the difference between how much U.S. investors have invested abroad and how much foreigners have invested in the United States) of over $16 trillion. Foreigners may nevertheless be willing to continue investing because (1) the United States has long had a negative NJJP and net capital inflows, (2) the United States has consistently earned positive net income on its NJJP despite it being negative, and (3) the dollar's unique role as the world's reserve currency creates consistent foreign demand to hold dollars for trade and as foreign exchange reserves. For more information, see CRS In Focus IFi11707, The UJ.S. Dollar as the World's Dominant Reserve Currency, by Rebecca M. Nelson and Martin A. Weiss.

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