South-Western College Publishing - Economics  
The Falling Dollar - Where Will It Go?
Subject Exchange Rates
Topic International Finance
Key Words Exchange Rates, Appreciation, Depreciation, Exports
News Story

The U.S. economy is doing very well, the stock market is hitting new highs, but foreign confidence in the United States Government - as measured by the strength of the dollar - is apparently falling. Huge budget deficits used to be blamed for a low relative value of the dollar, but the U. S. budget is predicted to have a $76 billion surplus this year. Given the turnaround in the budget deficit and the fact that the U.S. economy is closing in on the record for the longest peacetime expansion in the 20th century, it is hard to explain why investors are flocking to the yen. The dollar has depreciated nearly 25 percent relative to the yen since August.

Japan's economy is in recession and, in spite of a variety of government policies, has shown no signs of recovery. Consistent with the relative strengths of the two economies, the dollar was trading at 146 yen last summer with forecasts that the value of the dollar might appreciate to 160 yen. Instead, the dollar has fallen to 110 yen as of this week. The dollar also fell against the German mark, dropping about 6 percent.

There are many theories as to why this is happening. Some economists in the U.S. blame the growing trade deficit. Others argue that enthusiasm for the euro has caused a flight from the dollar. Still others point to an increase in Japanese interest rates that have resulted in capital flowing back to Japan. Some foreigners believe it is the impeachment trial of President Clinton. For example, HSBC Securities, part of the Hong Kong and Shanghai Bank Group, told investors to keep an eye on "political stability" in Washington.

In general, it is difficult to pinpoint a single factor or factors to explain currency movements. For example, it may be that last summer's appreciation of the dollar was too high and therefore, the recent movement is simply a correction. The U.S. Treasury has argued that sharp currency movements, in either direction, are destabilizing. Furthermore, a strong yen will hurt Japanese exports and diminish the prospects of a recovery, although Japan's government seems not to be too upset with the rise of the yen. One explanation for this surprising reaction is the fear that the yen would be replaced by the euro as the world's second currency.

(Updated February 1, 1999)

Questions
1. List some of the factors that determine the demand for dollars in Japan.
2. List some of the factors that determine the supply of dollars in Japan.
3. Suppose that the government of Japan thought that the yen/dollar exchange rate was too high. What measures could they adopt to lower the exchange rate?
4. How would the introduction of the euro affect the yen/dollar exchange rate?
Source David E. Sanger, "Sinking in Buoyant Waters", The New York Times, January 9, 1999.

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