the rise of the dollar

Sean Ling4/15/2023Prof. Chinn

The Rise of the Dollar

By Sean Ling


Introduction

The global economy has recently been endangered by the rising exchange rate of the US dollar

since the summer of 2014. In the US, the trade deficit has increased while employment in US export

industries has decreased over the last three months. However, a stronger US dollar could have its most

extensive effects on emerging markets. Although the US dollar isn’t anywhere near as strong as it was in

the early 2000s, where it was worth almost as much as the euro back then, in the past three months the

value of the dollar has risen by 11%; over the past year, by 22%. This is the fastest appreciation of the US

dollar since 1974, and is occurring seven years after Lehman Brothers declared bankruptcy in 2008. The

strengthening of the dollar has been remarkable considering where it was during the last three months

of 2008 at the height of the Great Recession. From September 2008 to the end of the year, the dollar

only rose by 5% against a basket of other widely used currencies even as the rest of the global economy

dove into a deep recession, causing investors worldwide to look for safety. This paper will discuss the

reasons behind this recent rise of the US dollar, its overarching impacts on international trade and global

economic output, and possible policy measures that could counteract the negative effects of the

stronger dollar as well as each measure’s benefits and drawbacks.

Analysis of Causes

Why did the US dollar risen so rapidly in 2014 while other major currencies did not? To answer

this question, it is imperative to know not only what currency depreciation and appreciation is, but also

understand the mechanisms that cause currencies to appreciate. According to Investopedia, “currency

depreciation is the loss of value of a country's currency with respect to one or more foreign reference

currencies, typically in a floating exchange rate system. Its opposite, an increase in value of a currency, is

currency appreciation.” A floating exchange rate is an exchange rate policy that typically allows for


fluctuations in the value of the country’s currency in a foreign exchange market. Currencies generally

appreciate due to increased demand for that specific currency in the global market. An increase in

demand for the US dollar from 2014 onward could be due to several reasons:

1. When a country's exports increase, the buyers of these exports need more of the country’s currency

to pay for those exports.

2. When a country's central bank raises interest rates, people will want to use that currency to deposit

in the country’s banks and earn that higher interest rate.

3. An increase in employment and per capital income in a country pushes up demand for the nation’s

goods and services, which are usually purchased using the local currency.

4. Increased government spending and borrowing tends to raise interest rates, resulting in the same

situation illustrated in reason number 2.

5. A loosening of fiscal policy increases aggregate demand in order to stimulate economic growth,

which is usually correlated with currency appreciation.

In the beginning of 2014, Europe and Japan’s economies stagnated, and China and other

emerging markets experienced lower rates of economic growth. During this time, America’s economy

looked relatively strong, with unemployment dropping to 6.3% and per capita income increasing to

$45,863, leading the International Monetary Fund to forecast 2.8% growth for the US economy from

2014 onward, as shown in Table 1.1. As a result, the US Federal Reserve began implementing

contractionary monetary policy by halting its purchase of financial assets and announcing its plan to

raise short-term interest rates. However, most foreign central banks were still conducting loose

monetary policy, allowing investors to make higher returns from dollar-denominated assets. This

boosted investment in US firms and government bonds and increased US bank deposits, causing both

foreign capital as well as the value of the American dollar to increase. Therefore, an amalgam of factors


mentioned above came together to create the situation in which the dollar has appreciated more rapidly

than it has in approximately forty years.

Impacts of a stronger US dollar

The strengthening of the dollar has had complex, far-reaching effects since 2014. The two most

obvious consequences are that foreign goods and services are now cheaper for American consumers,

and American goods and services are more expensive for foreigners. While this may encourage US

citizens to vacation abroad, increasing tourism income for these visited countries, it could also


discourage foreign citizens from traveling to the US, adversely affecting the American tourist industry.

Also, if expansionary monetary policy in response to the stronger dollar in foreign countries successfully

boosts their respective economies in the long-run, it will end up increasing American exports as well. So

far though, American firms that sell goods and services abroad have been adversely affected by the

stronger US dollar. Approximately 25% of the profits of firms in the S&P 500 are earned in foreign

currencies, which have weakened in comparison to the US dollar. This results in these firms doing more

business outside of the US because it is cheaper to do so. Although the rise of the dollar counters

inflation, which may be good for domestic consumers, it also makes the Federal Reserve less certain

about when it should adjust interest rates, which may negatively impact unemployment and investment.

Ultimately, the stronger dollar affects other countries more drastically than it does the US. The

cheaper foreign goods, services, and assets thanks to the dollar’s rise will help exporters in slower-

growing economies around the world, especially Europe. However, potential benefits to these foreign

markets from the stronger US dollar such as cheaper exports may not be enough to balance out the

problems created from the phenomenon. Foreign firms, specifically those in developing/emerging

markets, have been borrowing money using the US dollar because the interest rates on US private and

domestic loans has generally been lower than their domestic loans’ rates. In fact, the amount of debt

held in US dollars by non-financial borrowers outside America has grown by 50% since the 2007-2009

financial crisis according to the Bank for International Settlements. Emerging countries make up half of

this debt. In China, dollar-denominated loans increased from about $200 billion during the peak of the

Great Recession in 2008 to $1.224 trillion as of February 2015. The rising US dollar makes this dollar-

denominated debt more expensive to finance in local currency. In addition, the US Federal Reserve

began tightening monetary policy recently, which increases the interest rates charged on dollar debts.

This puts borrowers in a dilemma in which they not only have to account for a stronger dollar; they also

have to adjust to increased costs of borrowing and refinancing US bank and corporate loans.


Consequently, this interconnectivity of foreign investors and debtors with the US economy and its

central bank may ultimately slow down economic growth during a time when the world economy is still

trying to recover from the recent financial meltdown.

There are some mitigating factors of the impacts of a stronger dollar for these emerging markets

and European economies though. For instance, a large percentage of international corporate borrowers

has income and liabilities in dollars, allaying any concerns of currency mismatches. But many firms,

including oil or mining companies that do have matched debts and revenues have experienced declining

net income in dollars due to decreasing commodity prices. To make matters worse, other firms are

much more vulnerable to currency fluctuations. For example, in China, about a quarter of the country’s

corporate debts are dollar-denominated, but only around 9% of Chinese firm revenues are. It should be

noted that the yuan has hardly depreciated against the dollar, and China will probably not let it

depreciate anytime soon because it has fixed exchange rate system, also known as a pegged exchange

rate, in which changes in the value of the dollar are directly related to the value of the local currency. In

other words, China is artificially trying to facilitate trade and investment between the US and itself. But

pegging a country’s currency to the US dollar may not be the long-term solution, as it results in higher

unemployment, excess supply, or excess demand given an existing trade deficit. Therefore, a country

under this fixed exchange rate regime must avoid trade deficits, and may do so by imposing tariffs and

other trade protectionist measures which hurt economic growth in the long-run.

Additionally, although borrowers in emerging markets may have to pay interest on their debts

earlier than usual or refinance those same debts, exporters from these same markets may benefit from

decreasing local currency exchange rates. The flip side of this is that while the majority of emerging-

market businesses borrowing in foreign currency do so in dollars, exporters in these markets could end

up doing more business with other countries whose currencies are also depreciating against the dollar


than with America itself. So far, this phenomenon hasn’t happened yet, but its possibility illustrates how

a strengthening dollar could very easily add to these emerging economies’ foreign and/or national debt

while doing little to increase their overall exports.

Lastly, most emerging markets have sufficient foreign-exchange reserves that can be used to

bailout major local corporations affected by the stronger dollar. Unfortunately, not all countries have

this wealth of reserves available, so firms in these countries will probably have to fend for themselves.

Moreover, most of these emerging market nations have large short-term government debts that limit

stimulus of each country’s corresponding private sectors. All in all, while there are some positive

outcomes from the stronger US dollar, too many negative consequences from this situation exist for the

world economy to simply ignore.

Potential Policy Measures

There are several different ways the global economy could respond to the strengthening of the

American dollar. One solution is already in effect: central banks outside of the US have lowered their

respective country’s interest rates to stimulate investment and boost demand. While this monetary

policy results in a reduction in the value of a country’s currency, it may not work in the long-run as there

are many drawbacks from having artificially low interest rates. For instance, in any given country,

interest rates on savings accounts and certificate of deposits are huge determinants on how much

money individuals in that country will keep in the banks. Low interest rates can encourage people to use

their money to pay down their debts or invest in goods, services, or assets instead of keeping it in their

local banks, decreasing bank deposits and reducing the amount of available bank loans in the country’s

economy. Fewer loans from banks results in lower investment, a major component of a country’s GDP.


There are many other negative side-effects of lower interest rates. Decreased interest rates

affect insurance companies that rely on a certain interest-based return on the money they receive in

premiums to support their coverage liabilities. This may result in higher insurance premiums for a

country’s citizens, decreasing disposable income and in turn lowering aggregate demand. These same

lower rates also negatively affect people who live off interest income from their savings, causing them to

decrease consumption and once again lower demand. Central banks also have to make sure interest

rates don’t become abnormally low because if they do, banks won’t have a large enough deposit base

and the income from loans won’t encourage taking risks, causing banks to loan only to borrowers with

high credit ratings and sizeable assets to collateralize those loans. Finally, unusually low interest rates

may result in a liquidity trap. A liquidity trap occurs when interest rates are so low that expansionary

monetary policy becomes ineffective. In fact, liquidity traps typically result in a reduction in business

investment due to a shift toward investments in assets that don't produce employment, such as the

stock market and loan repayment/refinancing. This lack of job creation may exacerbate unemployment

rates in developing and emerging markets as decreasing business investment causes companies to lay

off expensive employees and employ freelancers and temporary workers at lower wages. Decreasing

wages in turn results in decreasing prices on goods and services, leading to more unemployment and

lower wages. This is known as of deflation, which is difficult to stop as the economy is trapped in a

vicious cycle. Consequently, lowering interest rates in emerging market nations is a short-term solution

at best, and has too many potential negative consequences for these countries’ economies in order to

be a good long-term response to the stronger dollar.

Expansionary monetary policy in general may prove ineffective for countries adversely affected

by the US dollar strengthening. In addition to lowering the interest rate, one of the tools of central

banks is to increase the money supply. This usually results in depreciation of the local currency, but too

much money in the economic system results in inflation because the money chases a fixed amount of


goods and services, increasing prices. Therefore, instead of decreasing wages, local goods and services

become more expensive as the local currency is now worth less than before, ultimately resulting in less

consumption, a chief component of a country’s GDP.

Emerging markets and advanced economies outside of the US could follow China’s model and

enter into a fixed exchange rate system in order to somewhat counteract the rising US dollar. This can

have several advantages. The two most important advantages are the elimination of exchange rate risk

and the decrease in intensity of negative economic shocks due to global recessions. Other benefits

include the enforcement of monetary discipline on the monetary authority of the affected country and a

reduction in economic instabilities stemming from inflation and deflation. On the other hand, keeping

the exchange rate of the local currency relatively fixed during a trade deficit necessitates deflationary

fiscal policy or austerity measures, which may result in higher unemployment. The other key drawback is

a high probability that the targeted exchange rate may not be the market equilibrium rate, leading to

distorted price signals. For example, an exchange rate that is set too high will result in excess demand,

as consumers believe that their money is worth more than it really is. A more subtle disadvantage is the

implicit cost of government intervention in the foreign exchange market that a fixed-exchange rate

system requires. Hence, a fixed exchange rate system can solve some economic problems, but it creates

just as many new economic problems as it fixes.

There isn’t a good quick fix policy that allows countries affected by the strengthening dollar to

sufficiently adjust. Each of the policies outlined above has significant drawbacks to its implementation.

Effective policy measures require an examination of the reasons behind the strong US dollar 5 years

after the 2007-2009 global recession. The rise of the dollar seems be indicative of America’s ability to

bounce back from economic downturns. While the US enjoys several economic advantages such as an

almost unlimited range of natural resources and a strong military that can defend trade routes and deter


direct attacks that other countries don’t have, there are certain policies that emerging markets and

other economies strongly influenced by the rising dollar can look to that will improve their own

economies. For instance, many emerging markets are governed by regimes with high levels of perceived

corruption. Corruption deters potential entrepreneurs and innovators because starting a new small

business or working up the corporate ladder in a corrupt country may require prohibitive bribes or

special favors to government officials. So, a reduction in corruption is a major step in stimulating

economic growth. Rule of law and stronger property rights need to be respected by the country’s

populace and enforced more effectively in many countries around the world. If not, businesses may

decide to pick up and move from a country with a high crime rate, especially if the government is

perceived as soft on crime. These firms may also leave if stronger property rights are not enacted and

enforced since they help protect firms from having their resources seized by others without legal

consequences.

There are also several fiscal policy measures that countries outside of the US can enact which

would allow them to economically compete with the US and subsequently raise the value of their own

currency due to higher output. Lower income and corporate tax rates could be implemented for at least

a short period of time in order to stimulate business investment and increase disposable incomes of the

country’s populace. The obvious drawback of such policy is the requirement to either increase tax rates

or decrease spending in the future so as to not accumulate national debt. As seen in Greece, increasing

the national debt also increases the probability of government insolvency, harming the country’s

financial reputation and economic growth prospects. Nonetheless, responsible tax cuts can stimulate

the economy as well as encourage other countries to do the same or face a potential outflow of

businesses from the higher-taxed country. Government regulations in several countries could focus on

fostering business competition by breaking up existing monopolies and oligarchies operating in the

country. The United States went through a period of time in which monopolies in the steel and oil


industry threatened to shut out competitors and stifle innovation. This has long since been remedied,

and can be an important lesson to several emerging markets concerning business regulation. Public

policy initiatives such as welfare-to-work and job training programs should be implemented with a goal

of lifting people out of poverty, thereby increasing aggregate demand. Finally, open market policies such

as low tariff rates and a highly developed financial and banking system send strong signals to investors

and businesses that the country with these characteristics will be easy to trade with as well as borrow

and lend money while in the country.

Every single fundamental improvement to an affected country’s market policies, business

climate, and rule of law explored above can be used to improve the country’s economic competitiveness

and quality of life index. Along with long-term effects on the nation’s business climates, the resulting

increases in employment and per-capita incomes would put upward pressure on aggregate demand.

Higher aggregate demand increases demand for the country’s currency in the local market, raising the

local currency’s exchange rate. Recent studies suggest that nations with more valuable currencies tend

to have higher GDPs per capita, more open economies, and more stable currencies. While there are

certain disadvantages of having the local currency appreciate, the benefits far outweigh the drawbacks,

as the country’s currency would no longer have a falling exchange rate relative to the US dollar.

Conclusion

In this paper, the topic of the rapid ascent of the US dollar’s exchange rate was explored and

identified as a problem requiring understanding and policy initiatives by all affected countries. Reasons

behind the stronger dollar that were discussed included the relative strength of the US economy from

2014 onward and expansionary monetary policy by foreign central banks worldwide, both of which

encouraged investment in US goods and services and increased demand for the US dollar. Next, impacts

of a strengthening dollar on both the US and global economy were discussed, with mixed implications


for future economic output for the US but an overall dismal impact on European and emerging markets.

The paper subsequently studied mitigating factors that could alleviate some of the negative effects of

the stronger dollar on these emerging markets and Europe and found them inadequate. Possible policy

fixes such as expansionary monetary policy by emerging market and European central banks were then

analyzed for their pros and cons concerning long-term growth. The best response to the rise of the

dollar involve general improvements in rule of law, business friendliness, and regulatory efficiency for

the affected countries with the goal of increasing European and emerging markets’ economic output.

Ultimately, the most beneficial policy initiatives revolve around new or additional free market reforms

for these economies outside of the US in order to allow these countries’ currencies to appreciate in

response to stronger economic growth, organically eliminating the negative outcomes of a resurgent US

dollar.


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the rise of the dollar

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