The weakening of the dollar raises concern in Congress and among the public that the dollar's decline is a symptom of broader economic problems, such as a weak economic recovery, rising public debt, and a diminished standing in the global economy. How might failure by the 112 th Congress to raise the federal debt ceiling or address the country's long-term government debt problem affect the exchange rate? Economic theory suggests that the dollar's path can be influenced by a variety of factors that could confer to the United States both benefits and costs, and in some circumstances a depreciating currency can be, on balance, beneficial. This report examines the several factors that are likely to influence the dollar's medium-term path; why further depreciation could occur; what effects a depreciating dollar could have on the economy, including the pace of economic recovery; and how alternative policy measures might influence the dollar's path. Broad Economic Forces That Affect the Dollar

Since the break-up of the Bretton Woods international monetary system in 1973, the exchange rate of the dollar has been largely determined by the market—the supply and demand for dollars in global foreign exchange markets. Dollars are demanded by foreigners to buy dollar denominated goods and assets. (Assets include bank accounts, stocks, bonds, and real property.) In most circumstances, however, there is a strong expectation that asset-market transactions will tend to be dominant and ultimately dictate the exchange rate's direction of movement. Determinants of the Size and Direction of Cross-Border Asset Flows

Economic theory suggests that several economic factors could influence the direction of cross-border asset flows. The Dollar is the Principal Global "Reserve Currency"

A reserve currency is a currency held in sizable quantities by foreign governments and central banks as part of their holdings of foreign exchange. One factor governing whether dollar depreciation is an orderly or disorderly adjustment is investor expectations about future dollar depreciation. The exchange rate, while usually not the primary target, can be affected by macroeconomic policies, such as quantitative easing, fiscal stimulus, and debt reduction. Policies to Influence the Demand for U.S. Assets

Given the importance of international asset markets in determining the dollar's exchange rate, policies aimed at directly or indirectly influencing the demand and supply of dollar assets would potentially have the greatest direct impact on the dollar. This would exert upward pressure on the dollar. To achieve an orderly correction of these imbalances that assures more stable exchange rates and leaves all the involved economies on sounder macroeconomic footing, mainstream economic thinking suggests that the needed rebalancing can be most efficiently achieved by a coordinated international policy response, the salient elements of which are
in the United States, raising the national saving rate via substantial increases in the saving rates of households and government and through that reducing the U.S. trade deficit to a "sustainable" size; in Japan and Europe, generating faster economic growth primarily propelled by domestic spending rather than net exports; in Asia (excluding Japan and China), fostering a recovery of domestic investment and reducing the outflow of domestic saving; and in China (and other surplus economies that fix their exchange rates to the dollar), allowing their currencies to appreciate and channel more of their domestic savings into domestic spending.
Depreciation of the dollar since 2002 raises concern among some in Congress and the public that the dollar's decline is a symptom of broader economic problems, such as a weak economic recovery, rising public debt, and a diminished standing in the global economy. However, a falling currency is not always a problem, but possibly an element of economic adjustments that are, on balance, beneficial to the economy.
A depreciating currency could affect several aspects of U.S. economic performance. Possible effects include increased net exports, decreased international purchasing power, rising commodity prices, and upward pressure on interest rates; if the trend is sustained, the United states may also experience a reduction of external debt, possible undermining of the dollar's reserve currency status, and an elevated risk of a dollar crisis.
The exchange rate is not a variable that is easily addressed by changes in legislative policy. Nevertheless, although usually not the primary target, the dollar's international value can be affected by decisions made on policy issues facing the 112th Congress, including decisions related to generating jobs, raising the debt limit, reducing the budget deficit, and stabilizing the growth of the federal government's long-term debt. Also, monetary policy actions by the Federal Reserve, over which Congress has oversight responsibilities, can affect the dollar.
The exchange rate of the dollar is largely determined by the market—the supply and demand for dollars in global foreign exchange markets associated with the buying and selling of dollar denominated goods, services, and assets (e.g., stocks, bonds, real property) on global markets. In most circumstances international asset-market transactions will tend to be dominant, with the size and strength of inflows and outflows of capital ultimately determining whether the exchange rate appreciates or depreciates.
A variety of factors can influence the size and direction of cross-border asset flows. Of principal importance are the likely rate of return on the asset, investor expectations about a currency's future path, the size and liquidity of the country's asset markets, the need for currency diversification in international investors' portfolios, changes in the official holdings of foreign exchange reserves by central banks, and the need for and location of investment safe havens. All of these factors could themselves be influenced by economic policy choices.
To give Congress the economic context in which to view the dollar's recent and prospective movement, this report analyzes the evolution of the exchange rate since its peak in 2002. It examines several factors that are likely to influence the dollar's medium-term path; what effects a depreciating dollar could have on the economy; and how alternative policy measures that could be taken by the Federal Reserve, the Treasury, and the 112th Congress might influence the dollar's path.