NOVAK DJOKOVIC GROUP

The Fluctuations of US dollar & its effects towards the world

Economy

Table of Contents

Page

1.0 ABSTRACT..................................................................................................................... 1

2.0 INTRODUCTION ............................................................................................................ 1

3.0 OBJECTIVES ................................................................................................................. 3

4.0 LITERATURE REVIEW .................................................................................................. 3

5.0 DISCUSSION AND FINDINGS ....................................................................................... 9

5.1 The Factors That Influence the US Dollar ................................................................... 9

5.2 The US Dollar Fluctuation Affected the World Economy........................................... 11

5.3 The Countries Have Been Affected .......................................................................... 14

5.4 Policy to Response ................................................................................................... 19

6.0 CONCLUSION .............................................................................................................. 21

REFERENCES

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1.0 ABSTRACT

This paper ties to study the fluctuations of US dollar and its effects towards the world economy.

It shows that the fluctuations of the US dollar are definitely bringing impacts towards the world

economy. From the research, we know that trade deficit versus the US dollar index, housing

bubble, size and liquidity of asset markets, interest rates, currency pegs, market psychology,

inflation and gold fundamentals is the key that affecting the US dollar and cause the

fluctuations. We also noticed that several countries are being affected. Lastly, American

government takes few policies to fight against the fluctuation of the dollar, which is FOREX,

monetary policy, fiscal policy and federal debt and the lower foreign trade barriers.

2.0 INTRODUCTION

The US dollar is the significant dominant currency of the world economy for almost a century.

There are no other economy came close to the size of the United States. Although the China

economy is rising, but it still cannot overtake the powerful United States. The US dollar had

been the de facto world reserve currency, which means that the US currency accounted for

roughly two thirds of all official exchange reserves. The US dollar is denominated in more than

four-fifths of all foreign exchange transactions and half of all world exports, and all of the IMF

loans. Therefore, the major movements in US dollar have important implications for the

prospects for the world economic growth.

An increase of the US dollar will lead the purchasing power of US consumers, and

following with the import demand. The higher import demand in United States will bring the

improved of the export and the economic performance in many international economies

especially those in European countries, Asia and Latin America. However, if the US dollar went

downturn in short period, this will bring the huge impact on the world economic growth. The

world commodity demand and prices will be affected. The reason of the world economy

dependent very much on the United States as a growth engine, therefore once the US dollar

depreciate, it will cause the reduction in US import demand and potentially to weaken the world

economic growth.

From a peak in early 2002 through the first half of 2008, the US dollar steadily

depreciated, dropping a total of about 25 %. In between, the US dollar has once sharply

appreciated, increasing more than 11% on a trade- weighted basis. However, the US dollar

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began to turn down again and fell about 16% in mid-2009 to mid-2011. The market uncertainty

because of the European sovereign debt crisis caused the dollar to appreciate more than 5%

through the end of 2011. In contrast, the dollar is again depreciation in the early 2012 because

of the return of some degree of financial normalcy in Europe. The dollar dropping from early

2002 through early 2008 as well as the recent depreciation has not been uniform against

individual currencies, however, in the earlier period, it drop 45 % against the euro, 24% against

the yen, 18% against the Yuan and 17% against the Mexican peso. US dollar also has a tough

period in the business cycle in middle 2009. The fading of the dollar raises concern in

Congress and among the public that the dollar’s decrease is a symptom of broader economic

problems, such as a weak economic recovery, the increasing of public debt and the diminished

standing in the global economy.

However, the dollar is still the world’s ‘safe haven’ currency. According to Fortune

Magazine (2011), the federal deficit and debt burden of America are ballooning; the trade are

imbalances with emerging countries are gaping wider. Then, the Federal Reserve has been

printing new money, diluting the value of each existing buck. Laurence Kotlikoff, an economics

professor at Boston University said that the United States is basically bankrupt, and it is the

major decline in the dollar over time. Besides that, United States also has the longer period of

the highest poverty rates in the developed world. According to Reuters (2010), the number of

Americans living below the poverty line rose to a new record of 46 million on the year 2009,

and this is a big challenge that The President Barack Obama and Congress faced, and they try

to tackle high unemployment and a moribund economy.

It is striking perception that the weakness of dollar will bring the yield economic

expansion without any reference to the structure of financial institutions in nations of Japan,

China or Europe. Koo (2003) also declared that the world is now entering the balance sheet

recession, which a big number of companies in economy no more fight for maximum profits but

are trying hard to strengthen their balance sheets after facing a major fall in asset prices. The

household sector still saving money while the corporate sector is no longer borrowing money,

this kind of fallacy of composition problem is created and pushes the economy ever deeper into

recession. Therefore, the United States have to try hard and figure out the best way to reduce

the harm of the fluctuation of US dollar towards the world economy.

The figure below has shown the fluctuation of dollar for these recent years. The trend

of dollar is decreasing.

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3.0 OBJECTIVES

The objective of this study is to investigate the factors that influence the US dollar. Secondly, is

to determine the impact of the US dollar fluctuation towards the world economy, and the

countries that have been affected the most. Lastly objective is to evaluate the policy that has

been implementing to the fluctuations of US dollar.

4.0 LITERATURE REVIEW

According to Barro (1986), U.S. dollar is used by the people as the basis for spot agreements

as well as for long term contracts. The inflation is associated with the U.S. dollar. Increased

volatility of nominal interest rates can have important effect on the required average real rate of

return on nominally denominated assets. Higher expected inflation tends to go along with low

realized returns on holdings of long term bonds. Future contracts in price indices would

alleviate the adverse consequences if expenses. The uncertainty inflation, cause the market

participants have serious problems in evaluating the real implications of nominally denominated

contracts, including dollar bonds. The effect on the risk and premium bonds depends on the

increase on the interest rates and tend to go along with good or bad economics. This could

Figure 1: Index of Trade-Weighted Exchange Rate of Dollar

Sources: Board of Governors of the Federal Reserve System

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affect the fluctuations of the U.S. dollar. If good times, bonds do badly in good times and vice

versa, which is desirably property that is consistent with low mean real rate of return on bonds.

In currency fluctuations a danger for firm operating globally, Casacchia (2007) affirmed that

multinational corporations are not doing enough to mitigate the risk associated with currency

fluctuations, unprepared for the financial hits. Foreign exchange risk is one element of the

volatility can manage and diversify. Political and changing of the economic views can change

business operations unexpectedly. The lower dollar certainly attracts tourist and spurs exports

sales in the U.S. American businesses pay more for imported goods. The difference of the

foreign exchange cause British and Canadian lost millions as their currencies continue its

appreciation. The transaction and the volatility of the U.S. dollar and other currencies introduce

the risk to bottom line. Dollars crept to new low and weaken the other currencies.

According to KPMG LLP (2009), the shockwaves from the credit crisis have buffeted

the U.S. dollar and weakened dramatically against the euro. Although the dollar regained

ground in the second half of 2008 after Congress passed the financial rescue package

designed to stem the liquidity crisis, it is still weak. A weaker dollar has been good for U.S

manufacturers in exports, making them more cost-competitive in foreign markets. However, the

impact of credit crisis has weakened consumer confidence, tighter credit markets,

unpredictable commodity and raw materials costs and the impact of at least a short-term

economic recession. To ride out the challenges ahead, the U.S, manufacturers can manage

their currency risk and balance their global investments by develop a foreign exchange risk-

management plan. The risks are transaction risk, translation risk, and economic risk. Next is to

understand where the exposure lie is and use hedging strategies to lower financial risk.

Moreover, establish the most favourable currency for transaction using spot transaction,

forward contracts and option contracts. Besides that, break down organizational silos and lastly

is pursue operational hedging by paying in local currencies where possible and consider

evaluating their global operations in the same way they would any other global asset portfolio.

KPMG LLP (2009) also stated that with the currency and commodity market volatility

potentially having a direct impact on the profitability of a given product, the ability to gather

informed analysis on price, supply, and demand risks is essential. Nevertheless, if the currency

exposures are well understood, evaluated, and quantified, a manufacturer can risk not only

margin and profit disruptions, but also a corresponding impact on share prices.

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Madueme (2010) claimed that the British pounds had the highest impact on

fluctuations in the United States dollars followed by the Euro then the Canadian dollar. The

United States dollar decreases 2.6% and 2% each when one unit increases in British pound

and Canadian dollar respectively. Those with lesser impacts are the Indian Rupee and the

Chinese Yuan while the Japanese Yen has the least impact on fluctuations in the United States

dollar. One unit of Japanese Yen increases the United States dollar by 0.001%.

According to Jayakumar and Weiss (2011), the American unipolar moment has faded.

The United State has no more hegemonic stability and unipolarity in the global reserve

currency. The future of global economy will revolve around a multipolar order with the rise of

China. China is now quickly redrawing the traditional Western dominated global economic

system. The attractiveness of the dollar standard diminish because of the structural challenges

that faced by the American economy which come along with the extraordinary expansion of

Federal Reserve’s balance sheet and the explosion of US government debt. The Global Credit

Crisis of 2008 – 2009 is the key point that causes the American unipolar to fade and bring the

rise of the China. The dollar’s pre-eminent status as the world’s reserve currency is expected to

give away over the next two decades because of the rising of the euro and the Yuan. This will

be the three primary reserve currencies, with no single currency enjoying significant dominance

over the others. Lastly, the shift away of the dollar centric global monetary order to a triploid

currency order is likely to have significant repercussions for the global economic system.

Penm, Maurer, Fairhead and Tran (2002) stated that the depreciation of the US

exchange rate will definitely affect the world economic growth and the world commodity

demand and prices. The significant impacts could be expected on Australian exports of

livestock products, minerals, and energy commodities which are sensitive to the world income

changes. The direction of movements in the Australian dollar is the vital factor in assessing the

implications for Australian commodity exports. A significant appreciation of the Australian dollar

against the US dollar would obviously decrease the earnings for the commodity exporters and

producers.

According to Goldberg and Crockett (1998) the year 1997 and 1998, the U.S. dollar

increased in value relative to the currencies of its trading partners. A dollar appreciation can

affect U.S. manufacturers’ revenues in two ways. First, a stronger dollar pushes up the price of

U.S. goods in export markets, making those goods much less attractive to foreign buyers and

reduced export sales for U.S. producers. Second, a stronger dollar can jeopardize the domestic

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sales of U.S. manufacturers by giving the foreign producers that have penetrated U.S. markets

a competitive edge in pricing. If the increase in net external orientation means that a strong

dollar could generate larger declines in revenues than in costs, we would expect a dollar

appreciation to lead to a drop in overall profitability.

From using nationally aggregated data for the 1975-93 periods, finds that a permanent

1 percent real appreciation of the dollar reduces real U.S. manufacturing profits by roughly 1

percent over the long run. Previous researcher confirms the expectation that a stronger dollar

will lead industries to reduce investment spending. Another factor is industry profit structure,

when the dollar rises, the most extensive cuts in investment spending occur in industries with

the lowest price over cost mark ups. Stronger dollar is correlated with job losses in some states.

Recent studies have confirmed expectations that a dollar appreciation will significantly reduce

producer profits and restrain investment spending. Strong dollar depresses wage growth and

may create churning in many industries.

Waring (2009) said the main reasons that many countries hold U.S. dollars is so they

can use those dollars to fix the value of their currency to the U.S. dollar. Before the September

11th attacks, the U.S. dollar was considered a ‘safe haven’ currency which would strengthen in

times of global uncertainty, as the United States was considered one of the safest and most

stable places in the world. However, the events of September 11th diminished the U.S. dollar’s

status as a safe haven currency and it has struggled to regain this status ever since.Many

commodities such as gold and crude oil are quoted in U.S. dollars in the international markets.

Many countries use the U.S. dollar in international transactions for this reason. This creates a

lot of demand for the dollar, which helps keep the foreign appetite for the currency strong. the

factors that traders watch when trying to determine the long-term fundamental position of the

dollar. These factors are The dollar’s status as the world’s reserve currency ,Countries

willingness to use the U.S. dollar in their ,currency pegs and the soundness of those

pegs ,Foreign interest in the U.S. dollar and dollar denominated assets from individuals and

corporations and The pricing in dollars of commodities in international markets.

The factor that contributes to the fluctuation of U.S. dollar includes the relationship

between the crude oil price and exchange rates. Yousefi and Wirjanto (2004) showed that

when the U.S. dollar depreciates (appreciates), oil suppliers tend to raise (lower) export prices

in order to maintain their mutual level of revenue. It can be seen that the majority of crude oil

trading takes place in U.S. dollars, and that oil is still the world’s primary energy source, it

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makes sense that variations in the international trading of crude oil should have a significant

impact on the relative valuation of the U.S. dollar (USD).

Somehow, there are also provided indirect evidence that USD exchange rates have a

significant influence on the oil price. For example, Indjehagopian, Lantz, and Simon (2000)

found that variations in the DEM/USD and FRF/USD rates had an immediate impact on

German, French, and Rotterdam heating oil prices. Sadosky (2000) showed that the effective

USD exchange rate transmitted a shock to crude oil, heating oil, and unleaded gasoline prices.

Yousefi and Wirjanto (2004) demonstrated that the export prices of crude oil from OPEC

(Organization of Petroleum-Exporting Countries) react to changes in the USD exchange rate.

Zhang, Fan, Tsai, and Wei (2008) documented a significant, long-term influence of the USD

exchange rate on the international crude oil market, but found that any short-term and

immediate influences were quite limited.

However, the Congress and the public started to worry when a trend depreciation of

the dollar since 2002. The reason is 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. A depreciating currency will impact the 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 high risk of a dollar crisis.

Therefore, the governmental policy is existing in order to response to this fluctuation of

U.S. dollar. Those governmental policy included the monetary policy actions by the Federal

Reserve, over which Congress has oversight responsibilities, can affect the dollar. But the

exchange rate is not a variable that is easily addressed by changes in governmental policy.

The exchange rate of the dollar is largely determined by the market which is 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, however, 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. This will cause the fluctuation in U.S.

dollar.

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The Federal Reserve actions are influence with the international economy. For

example, if Federal Reserve actions raised US interest rates, there will be an increase in the

foreign exchange value of the dollar, in turn would raise the price in foreign currency of US

goods traded on world markets and lower the dollar price of goods imported into the US. They

could lower output and price level in the US economy by restraining exports and boosting

imports. Moreover, the US monetary policy action has significant effects on growth and

inflation in foreign economies. The Federal Reserve and other countries to maintain a

continuous dialogue enables the Federal Reserve to better understand and anticipate

influences on the US economy and discuss topics of mutual beneficial. The purpose of Federal

Reserve foreign currency operations has evolved in response to changes in the international

monetary system, which from a system of fixed exchange rates to a system of flexible

exchange rates for the dollar in terms of other countries’ currencies. Under the flexible

exchange rates, the main aim of Federal Reserve foreign currency operation has been to

counter disorderly conditions in exchange markets. The effects of intervention on Federal

Reserve balance through open market operation could be offsets by the Federal Reserve. The

US holdings of foreign exchange reserves is the main source of foreign currencies used in US

intervention operations. The US monetary authorities have arranged swap facilities with foreign

monetary authorities to support foreign currency operations. The Federal Reserve plays a

function as bank supervisor in international banking institutions to help interpret US monetary

and credit conditions.

The US dollar has been the dominant currency of the world economy and had been the

world reserve currency. There are approximately two third of the US currency accounted as

official exchange reserves. In addition, more than four fifths of all foreign exchange transactions

and majority world exports are denominated in dollars, as well as IMF loans. The purpose of

introduction the euro had for diversification into dollar for investors who had obtained portfolio

balance by holding European currencies. The stability between the exchange rate of the euro

and the dollar has increased the value of the currencies and become more closely correlated.

The European Union countries adopted the euro as their common currency which directly

competing with the dollar. Start from 2002, the euro has gained widespread international

acceptance resulting in important institutional, economic and financial markets for Euro zone,

the US and the world economies. For example, the euro has been widely using in Latin

America, which the country reference currency is the US dollar. The flow of direct European

investment toward Latin America has reached the level comparable with the US. Moreover,

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according to the Bank for International Settlement Russian banks, that have been significantly

increasing their euro denominated debt and have continue to migrate from banks in the US to

banks resident in Europe. In the future, the euro might be playing an important role in the

international market just like the US dollar.

5.0 DISCUSSION AND FINDINGS

5.1 The Factors That Influence the US Dollar

The factors that directly affecting the U.S dollar are trade deficit versus the U.S. dollar index,

Housing bubble, Size and liquidity of asset markets, Interest rates, currency pegs, market

psychology, inflation, gold fundamentals.

How the trade deficits versus the U.S. dollar index affect the U.S. dollar? Trade deficit

reflect the excess spending in the domestic economy and reliance on capital imports to finance

that shortfall. According to Nanto and Donelly (2011), The rising of the trade deficit with

downward pressure on the value of the dollar, which help to shrink the deficit by making the

U.S exports cheaper and import more expensive. Increase in the trade deficit may diminish

economic growth, this is due to the net exports are a component of gross domestic products.

U.S trade and current account deficit might lead to large drop in the value of the U.S dollar. If

the foreign investors stop offsetting the deficit by buying dollar denominated assets, the value

of the dollar will drop too. The inflows of the capital to compensate U.S trade deficit and a low

U.S saving rate are help to maintain the value of the dollar.

Next factor is the housing bubble. Housing bubble could be defined rapid speculation

in house value until they reach unsustainable level relative to incomes or some other economic

fundamentals. Mckibbin and Stoekel (2006) declared that the boom in the house prices was

driven by historically low interest rate and lack of perceived returns on stock markets following

the bust of stock market boom in 2000. Rising prices of the houses generated expectations of

rise in property value, fuelling the additional speculative demands because of the investor shift

preferences from stocks to property. House price is affecting the U.S. economy. When the

investment flow to offshore assets the capital movement generates change the current account

balances, exports and imports, and real exchange rates. Housing price will cause the property

of the consumers increase, hence the wealth will be increase and vice versa. So the housing

bubble would directly influence the U.S. dollar.

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Size and liquidity of U.S asset markets also is one of the factor influence the U.S.

dollar. U.S has offered the variety of asset types and high degree of liquidity. U.S. treasury

securities as the high liquidity assets have attractive the foreign investors in this recent years.

Elwell (2012) stated that the highly liquid dollar assets has attract the foreign central bank,

which rapidly increase their holding of foreign exchange reserves, a substantial portion of which

are thought to dollar assets. It could influence the U.S dollar to become more valuable because

the highly liquid treasury securities.

In addition, interest rate also influences the fluctuation of the U.S. dollar. The demand

of the foreigners is strongly influenced by the expected return of assets. Atinc, Atinc and

Uwakonye (2011) stated that if the banks choose to use fed as source of monetary holdings,

the cost of borrowing is determined by the discount rate. U.S fed lower the FED funds due to

extreme weakness of the U.S. economy because U.S can’t afford to pay high real rate on its

currency. Thus, it will lower real rate and weaken U.S dollar.The foreign investors have been

keen to buy U.S. Treasury securities because they are considered a ‘safe’ investment. In order

to purchase Treasuries, foreign investors need to exchange their currency for U.S. dollars, thus

increasing demand for the U.S. dollar and causing it to appreciate or strengthen against other

world currencies. According to Bedel (n.d.), when the interest rate earned on U.S. Treasuries

declines, the investment is less attractive to foreign investors and their money goes elsewhere,

causing the dollar to weaken.

Furthermore, currency peg also cause the fluctuation of the U.S. dollar. A currency peg

is when one country fixes its currency against that of another country. This means that the

pegged currency will rise and fall in line with the currency it’s pegged to. FT (2008) stated that

the peg will happen because normally a weaker currency would peg itself to a stronger one. By

putting a peg in place a government deprives itself of the ability to interfere with domestic

monetary policy. Interest rates have to be set to maintain the fixed rate against the ‘peg’ and,

like the currency, will likely reflect interest rate moves of whatever central bank controls the

‘pegged to’ currency. This gives the reassurance of a commitment to price stability, which in

turn should eventually allow lower interest rates and help the pegged currency to gain that all-

important credibility. The stability of the currency will lead to dollars become stable.

Next factor is the market psychology. Investors have expected the future path of the

dollar. The expected dollar depreciation lowers the expected return and reduce the

attractiveness of the dollar assets to the foreign investor while if the exchange rate is expected

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to be appreciate, the expected gain will greater than nominal interest rate. The currency trader

speculative in nature and is designed to profit from short to medium term trends. It will make

trades in an anticipation of economic announcement such as GDP, inflation numbers and the

central bank announcements. The other type is the traders make the technical analysis to the

look over the trends and the chart patterns to predict the movement. Following from that, there

may be a flight to quality in a particular currency as a result of worldwide economic stress.

Inflation also would influence the U.S. dollar. Inflation erodes the purchasing power of

a particular currency and occurs when the growth in the money supply is higher than the

growth in GDP. If GDP remains constant with a money supply that is increasing, consumer will

need more money purchase the same amount of goods, leading to higher prices and a weaker

currency. High nominal interest rates might not indicate a strong currency, as the inflation rate

may be high as well. The concept of purchasing power parity states that the cost of an identical

good should be the same around the world. Thus, it will affect the U.S dollar.

The last factor is the gold fundamentals. Gold have the close significant relationship

with U.S. dollar. Responsible gold, org shows that a falling of the dollar increase the purchasing

of the non dollar area countries and driving up price of the commodities including gold. Unlike a

currency, the value of gold cannot be affected by the economic policies of the issuing country

or undermined by inflation in that country. Gold also brings much needed diversity to a central

bank portfolio due to its low correlation with key currencies and its strong inverse correlation

with the US dollar. The gold can influence the U.S dollar. It would stabilize the U.S. dollar.

5.2 The US Dollar Fluctuation Affected the World Economy

The United State economy and the world economy are linked in many ways such as foreign

direct investment, export and import, international banking transaction and so forth. And, the

US is a vital destination for exports from other economies. The US dollar is widely used in

international transactions; therefore, the fluctuations in the US dollar have important

implications for prospects for world economic growth.

The gradually depreciation of the dollar against a number of currencies is useful and

would help in facilitating the rebalancing of the huge US current account deficit. US exports

become cheaper and increase in demand for US exports. In short, it is certainly a stimulus for

US exporters and will support expansionary fiscal and monetary policies to get the US

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economy to faster growth. In addition, this would provide the much needed time for current

recovery of strengthen domestic demand and broaden in the Asian and Western European

economies.

However, the impact on various world economies would be different because under

such international exchange rate changes. The competitiveness of US made products on world

markets would gradually increase and hence provide support for US economic activity.

Nevertheless, a strengthening in the euro and the yen against the US dollar would restrain

growth in exports from Western Europe and Japan to the US, as well as to some other

countries, including China and Malaysia, that have their currencies pegged the US dollar.

While the impact of a gradual decline in the value of the US dollar might be beneficial

for the world economy, a sharpen depreciation in the US currency would be destructive for

world economic growth, especially if it were to happen at the current stage of world economic

recovery. This is because of weak domestic demand in the Asian economies and a sharp

decline in their export performance could trigger a slump in consumer and business confidence,

leading to a decline in domestic demand. The resulting would definitely lead to a significantly

weaker economic growth.

A marked reduction of import demand due to US consumer find imports more

expensive would have significant effects on the economic performance of its major trading

partners. This could lead to lower growth in other countries especially those who rely on

exports to US. For example, Canada and Mexico, both countries supply more than 80 percent

of their export to the US.

As well, the Japanese export sector would be adversely affected by a significant

reduction in import demand in the US. Besides the direct effect through reduced export activity,

there would be significant downside risks surrounding economic activity in Japan. The

weakening in Japan’s export performance could result in a marked increase in nonperforming

loans and corporate bankruptcies. The adverse effects on consumer and business confidence

could lead to a more significant increase in unemployment and a sharper decline in consumer

spending. Therefore, import demand could fall markedly, despite a significantly stronger

Japanese yen against the US dollar.

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Once the US dollar was to depreciate sharply, the export performance of Western

Europe would also be adversely affected. Western Europe is a major provider of capital to the

US, a reduction of capital inflows to the US means that capital outflows from Western Europe

would decline too. The adverse effects of lower export performance on economic growth in

Western Europe would be largely offset by the benefits of a reduction of capital outflows from

the region.

After all, those whose currencies are tied or pegged to the US dollar with respect to

transactions and upward or downward variations would tighten the weakening dollar. As far as

these countries are concerned, the depreciation dollar leads to rising inflation which expands at

the expense of the growth rates. Hence, as inflation increases, the nations are forced to double

their economic activity to maintain high growth rates. The list of emerging economies facing this

difficulty includes China, Russia, India, and Arab. In these countries, as their currencies are

pegged to the dollar and their economies rely on exports cause the inflation rapidly eats into

the public budgets heavily dependent oil revenues.

Recently, China is the largest foreign holder of US treasuries which has support the

value of the US dollar. China pegs its currency, the Yuan; lower than the US dollar to keep its

export prices competitive. However, the downgrade of the US credit rating and the falling value

of US debt are bad news for China’s large holdings of foreign exchange assets which are

denominated in US dollar. As the US largest credit holder, China is aware of its possible losses.

The debt crisis would result in a decline in demand in overseas markets and possibly affecting

China’s exports.

According to Jierui (2011), Zhang Xiao Qiang, deputy head of National Development

and Reform Commission stated, the US Federal Reserve’s policy of keeping interest rates

nearer zero until 2013 will lead to higher worldwide inflation, and higher commodity prices. If

the US continues its loose monetary policy, it will hurt the purchasing power of China’s foreign

exchange reserve. Besides that, concerning with the depreciation of US dollar is stoking

inflation in China; he also said that China is facing high unemployment, high inflation, and weak

consumption demand. This will definitely have a negative impact on China on its exports and

commodity prices. Briefly, the dollar’s depreciation against the world currencies and imposes a

burden on the world economy.

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The US dollar appreciated significantly against major international currencies between

1997 and early 2002. On a trade weighted basis, there was around 30 percent of the value of

the US dollar increased over this period. While, the US dollar appreciated would increase the

purchasing power of US consumers, and hence increase import demand. Higher import

demand in the United States will lead to improved export and hence economic performance in

many international economies especially those in Europe, Asia and Latin America. For example,

if the dollar appreciates against the yen, then Japanese produces selling to US markets will find

that their dollar revenues translate into more yen than in the past. The strong capital inflows

have increased the spending capacity of US business and households. Thus, the import

demand in the US increase substantially has leading to the market widening of the trade

imbalance.

5.3 The Countries Have Been Affected

The economy of the Middle East is very varied. The Middle East countries Bahrain, Cyprus,

Egypt, Iran, Iraq, Jordan, Israel, Kuwait, Lebanon, Oman, the Palestinian territories, Qatar,

Saudi Arabia, Syria, Turkey, United Arab Emirates, and Yemen are the individual economies

range from hydrocarbon exporting renter economies to government led socialist economies to

free market economies. According to Canova and Ciccarelli (2011), most of the countries are

best known for producing and exporting oil. The wealth is generate and through the movement

of the labour had significantly impact the entire region. For example, the Bahrain is the country

which owns largest oil deposit with small population per capita GDP of $27300. This state had

prolonged industrial capacity to refining capacity that outstrips its own oil production. These

Middle East countries are influenced by US dollar fluctuation.

The economic conditions in the United States create a consistent demand for USDs

and upward pressure on the USD’s value. This situation allows the US government gain

revenues through issuing bonds at lower interest rates. As a result the U.S. government able

run higher budget deficits at more sustainable level compare to other countries. The stronger

USD will able make the imported goods into United States are relatively cheap.

According to Coudert, Mignon and Penot (2008), the most oil sales especially in Middle

East are dominated by United States dollar (USD). This fact had been supported by proponent

of the petrodollar warfare hypothesis; because according to the hypothesis most countries

which are depend on oil imports had been forced to preserve large stockpiles of dollars in order

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to continue their imports. These countries need to preserve large stockpiles of dollar because

of the status of the United States dollar as the world’s dominant reserve currency and as the

currency in which oil is priced.

As oil trade from Middle East Countries such as Iraq, Iran, Saudi Arabia, United Arab

Emirates, Libya, and Kuwait is dominated in US dollars, movement in the dollar effective

exchange rate affect the price of oil as perceived by all countries outside the United States.

Hence, change in the dollar exchange rate can cause changes in oil demand and supply,

eventually changes in the oil price itself. Secondly, the reserve causality can also be found, as

changes in oil prices may well influence the effective exchange rate of the dollar. For example,

in the model by Farugee (1985), the exchange rate will value if a country accumulates foreign

assets, and this movement occur without looming its current account balance. It is because the

capital income takes over the lost in trade receipts induced by deteriorated competitiveness.

Third, stock of portfolio model also will influenced by the US dollar fluctuation. According to

According to Fezzani and Nartova (2011), there are designed to take account trade and

financial interaction between United States, and Middle East countries.

Coudert etc. (2008) declared that declared that the impact of US dollar effective

exchange rate is seen on oil demand and supply, since it affects the price of oil which is

produced by Middle East countries. The oil was perceived by all customers and oil producers

outside of US. These effects depend on currency used in different transactions linked to oil

activities. Moreover, the US dollar fluctuation also effect on demand. The oil which has been

purchased are paid using dollar. However, demand depend on the domestic price for consumer

countries which usually change according to dollar fluctuation. Therefore, the dollar

depreciation can reduce the oil price in domestic currency for countries with a floating currency.

The dollar depreciation generally tends to decrease the oil price in consumer countries. Based

on this situation, it can lead to an increase in their real income and increase in their oil demand.

Therefore, the dollar depreciation prior has a positive impact on oil demand and should

contribute to raise the price.

On the other hand, Coudert etc. (2008) stated that the US dollar fluctuation also can

effect on supply of oil. Normally, the oil company use domestic currency of procedure countries

to pay their employees, taxes, and other cause which the currency are often linked to the dollar

because of the fixed exchange rate regimes adapted by most producer countries. As a

consequence, dollar changes perhaps affect the price as perceived by the producer than the

16

one perceived by demanded. Generally, the dollar depreciation may result in a deduction in oil

supply. The dollar effective depreciation cause an increase in oil demand and the deduction in

supply, mainly on the long run which tends to boost oil price.

According to Coudert etc. (2008), the increase in oil price stems from to simultaneous

factors, first is strong surge badly anticipated of oil demand particularly in United States.

Second is according to Jackson (2010), dwindling investment in the oil sector that lead to

stagnation of production capacity. However, those demand and supply effects the dollar

depreciation which associated to a drop in oil price, not raise. The dollar depreciation required

to stabilize the US external position. However, it is not complete since it overlooks the

multilateral natural of exchange rate. Besides that, dollar depreciation can also cause inflation

and reduce the income in oil producer country because the currencies are linked to the dollar.

The increase inflation and the decrease in purchasing power reduced the real disposable

income and therefore available for drilling, everything else equal.

Countries like Japan and China are large purchasers of US debt. China in particular

has exhibited an insatiable appetite for US debt. Its rapidly growing economy is greatly

dependent on exports, and the US is one of its largest trading partners. In any given year, the

US imports much more from China than it exports to China. As a result there is a net flow of

dollars to China. Normally, one might expect China to sell these dollars on the global market,

causing the dollar to weaken. As an alternative China is reinvests its dollars in US debt. In

doing so, China strengthens the US dollar and limits the appreciation of its own currency. As a

result Chinese exports remain cheap to American consumers. However, due to large deficits

many countries, China, Russia and India in particular, have begun to reconsider diversifying

their reserves to protect themselves from a devaluation of the US Dollar. The decision of these

large countries to shift increasingly towards Gold as a reserve currency greatly decreases the

demand for US Dollars and weakens the USD.

The Chinese currency is presently fixed to the value of the US Dollar, so as the value

of US Dollar changes on international currency market, the relationship between the Chinese

Renminbi and the US Dollar remain the same. Some countries say that this does not give a

true indication of the strength of the Chinese currency internationally and there is pressure on

China to change the current relationship to the US Dollar. When the dollar declines, it makes

U.S. produced goods cheaper and more competitive when compared to foreign produced

goods. This helps increase U.S. exports, boosting economic growth. However, it also leads to

17

higher oil prices in the summer, since oil is priced in dollars. Whenever the dollar declines, oil

producing countries raise the price of oil to maintain profit margins in their local currency. The

growing U.S. debt weighs in the back of the minds of foreign investors. That is why they may

continue to gradually move out of dollar-denominated investments - slowly, so they do not

diminish the value of their existing holdings. The best protection for an individual investor is a

well-diversified portfolio that includes foreign mutual funds.

The political climate in Liberia is still not stable to the point to ensure that capital flight

will not lead to massive outflow of US currency in circulation. Political disharmony and

discontent serves to reduce investor confidence and in turn creates artificial capital flight

tendencies in the economy. The Liberian economy is currently too dependent on the US dollar

denominated incomes of foreign aid workers and remittances from Liberian nationals from

overseas as a proportion of GDP. During the civil war years, Liberia’s foreign reserve position

was completely depleted. According to Donzo (2009), recent report places it somewhere

around $50 million dollars and even this is too small an amount to support a full dollarized

Liberian economy, although Liberia has done quite well in recent three years to negotiate the

cancellation of a large portion of its foreign debt. The export earning capacity is still weak and

there is still a trade deficit that will only become corrected when some of the newly-signed

foreign investment contracts start to yield export earnings and boost the foreign exchange

revenues of the government. A return to the US dollar as the only legal tender means that the

country’s central bank will continue to operate as a bank or non-issue. It would be even less

limited than now to exercise its role as a central monetary authority. Besides that, allowing a

dual currency regime or semi-dollarization to exist now might offer some time to build the

confidence needed to strengthen the exchange rate and overtime if the economy and

exchange rate becomes strong enough, perhaps an attempt could be made toward full

dollarization. However, this should be a political as much as an economic decision because

should the variables to support dollarization falters. Lastly, a national currency is not only the

medium of exchange; it is also a symbol of sovereignty for many countries. It embodies a since

of economic independence or of national identity.

Japan's economy is challenged by rising commodity prices; the country imports most of

its food and oil, and a shrinking labour pool, as its population ages. Japan's worst challenge is

a national debt that is twice as big as its annual economic output. Like the U.S, much of

Japan's debt resulted from efforts to stimulate its economy out of a 20-year deflationary period

18

and recession. A recession in Japan could cause it to purchase less Treasury bonds at a time

when the U.S. is issuing more bonds to finance the economic stimulus bill and bailouts. Lower

demand and greater supply of Treasury bonds will cause yields to rise, thus raising interest

rates, further depressing the housing market.

The dollar exchange rate affects the output of the East Asian economies in both trade

and foreign direct investment. When the East Asian economies keep their exchange rates

stable against the U.S. dollar they must cope with extreme fluctuations of the dollar against the

yen. During the crisis of 1997, the currencies of Indonesia, Korea, Malaysia, Philippines and

Thailand were attacked. They had to end their dollar pegs and allow their currencies to

depreciate. Singapore and Taiwan also followed with currency depreciations. However, Olson

(2007) claimed Japan’s currency depreciated by more than 30 % during the 1997-1998 time

period. This resulted in severe deflationary pressures on the dollar prices of goods and

services traded in the region. The wide fluctuations in the dollar rate over the last 20 years or

more have created and influenced a business cycle in the smaller East Asian economies

(ASEAN4). The East Asian exchange rates are still susceptible to the fluctuating dollar

exchange rate. There are positive effects when the yen appreciates. For example, Olson

(2007) stated that the Japanese FDI increases and the other East Asian countries exports

become more competitive against Japan’s exports. However, when the yen depreciates against

the dollar (1997-1998), their output decreases, FDI from Japan decreases and their exports

become less competitive.

Ahmed (n.d.) claimed that the dollar fluctuation also gives an impact to India economy.

The rate at which a currency can be exchanged is the rate at which one currency is sold to buy

another. India FX rate system was on the fixed rate model till the 90s, when it was switched to

floating rate model. Fixed FX rate is the rate fixed by the central bank against major world

currencies like US dollar, Euro, and GBP. Like 1USD equal to Rs. 40. Floating FX rate is the

rate determined by market forces based on demand and supply of a currency. If supply

exceeds demand of a currency its value decreases, as is happening in the case of the US

dollar against the rupee, since there is huge inflow of foreign capital into India in US dollar.

Indian rupee appreciation against dollar impacted heavily to the exporters. Exports from India

are of handicrafts, gems, jewellery, textiles, ready-made garments, industrial machinery,

leather products, chemicals and related products. Since the 1990s, India is the world’s largest

processor of diamonds. The mentioned export items contribute substantially to foreign receipts.

19

Imports to India are of petroleum products, capital goods, chemicals, dyes, plastics,

pharmaceuticals, iron and steel, uncut precious stones, fertilizers, pulp paper so on. This gain

on FX is likely to create savings in cost, which could be passed on to consumers; thereby

contributing to control inflation Foreign investment into India is also contributing well to dollar

depreciation against dollar. With the recent liberalized norms on foreign investment policy like

Foreign investment of up to 51% equity limit in high priority industries, foreigners and NRIs are

allowed to repatriate their profits and capital with exception for Indian nationals who were

allowed to do so only under special circumstance and allowing free usage of export earnings to

exporters, made foreign investment in India very attractive. It is this favourable atmosphere

which made FX reserve surplus in US dollar and helped rupee to appreciate.

Arieff, Weiss, and Jones (2009) said that the value of total U.S trade with Africa had

increased by about 29% between the year of 2007 and 2008. After the continuous growth

within the three years the value of Africa’s exports to United States decreased in value by

about 57% in the first six months of 2009. U.S exports to Africa decreased in value by about

9%. The decline in value of U.S imports from Africa largely reflects the decline in oil price from

late 2008 through early 2009, as oil and mineral fuel account for about 80% of all U.S imports

from Africa, and 92% of all U.S. import. Petroleum imports did not decrease in volume as

dramatically as they did in value, however the decrease in U.S. and global consumption are

likely to continue to have a negative effect on most export from the region. According to Bower,

Geis, and Winkler (2007), commodities had play an important role in the economies of most the

24 countries in Western and Central Africa (WCA), which derive the majority of their

merchandise export revenues from one single commodity or several commodities. Most WCA

economies developed positively between 1999 and 2005, although differences between net oil-

exporting and importing countries were clear. Net oil exporters recorded the highest growth

rates, mainly supported by rising investment and exports on the back of record oil prices and

expanding oil in some countries. Rising oil prices make burden on WCA economies, which

often counteracting benefits accruing from rising prices for their own main export products.

5.4 Policy to Response

Since 1973, Bretton Woods fixed exchange rate international monetary system failed to

execute successfully, the de facto U.S. dollar policy has took over the role to determine the

dollar’s value. According to Elwell (2012), Treasury Secretaries claim that United States has a

strong dollar policy but have rarely taken direct steps to influence the dollar’s value.

20

The demand and supply of dollar assets will have the greatest direct impact on the

dollar fluctuation. The policy that has taken by the U.S. government against the fluctuation of

dollar is government direct intervention in the Foreign Exchange Market. This policy

involves the Federal Reserve at the request of the Treasury buying or selling foreign exchange

in order to influence the dollar’s exchange rate. To strengthen the dollar, the Fed could attempt

to boost the demand for dollars by selling some portion of its foreign exchange reserves in

exchange for dollars. However, the scale of the Fed’s foreign exchange holdings is small

relative to the size of global foreign exchange markets, which have a daily turnover of more

than $4.0 trillion. In this case, the Fed will inadequate to counter a strong market trend away

from dollar assets and prevent depreciation of the dollar. Following from that, there is a

coordinated intervention by the Fed and other central banks. This would have a greater chance

of success because it can increase the scale of the intervention and have a stronger influence

on market expectations. For example, the Plaza Accord of 1985 to weaken the dollar, the

Louvre Accord of 1987 to stop the dollar’s fall, joint actions with Japan in 1995 and 1998 to

stabilize the yen/dollar exchange rate, G-7 action in 2000 to support the newly introduced euro,

and G-7 action in 2011 to limit appreciation of the Japanese yen.

The next policy in response to the fluctuation of the U.S. dollar fluctuation is the

monetary policy. Changing the level of interest rates can also influence the U.S. dollar. A

tighter monetary policy would tend to strengthen the dollar because higher interest rates, by

making dollar assets more attractive to foreign investors, other things equal, boosts the

demand for the dollar in the foreign exchange market. In contrast, lower interest rates would

tend to weaken the dollar by reducing the attractiveness of dollar assets. However, in the

current macroeconomic situation, if the Fed intended to prevent the dollar from depreciating, it

would be constrained from applying the monetary stimulus in order to promote economic

recovery. Currently, the Fed’s policy of monetary stimulus is keeping interest rates low, and

exerts downward pressure on the dollar as well.

Other than that, the fiscal policy and Federal debt will also impact the U.S. dollar.

Government’s spending and taxing will influence the exchange rate. Budget deficits tend to

have a simulative effect on the economy. Yet, because the government must borrow funds to

finance a budget deficit, it increases the demand for credit market funds, which, other things

equal, tends to increase interest rates. Higher interest rates will tend to increase the foreign

demand for dollar-denominated assets, increase the exchange rate. However, in the current

21

state of the U.S. economy, with a sizable amount of economic loose and weaker than normal

private demand for credit market funds, current government borrowing does not appear to have

high market interest rates, and therefore does not able to rise the exchange rate. These

conditions will continue to slow down the raising of interest for currently anticipated government

borrowing and continue to exert minimal upward pressure on the dollar. After all, as economic

recovery move the U.S. economy closer to full employment and the private demand for credit

market funds increases, continuing large government budget deficits may result in higher

interest rates. Some foreign investors could be attracted by these higher interest rates,

increasing their demand for dollar assets. This would exert upward pressure on the dollar.

Policies that tend to increase the foreign demand for U.S. goods and services also

tend to strengthen the dollar. The policy of lower foreign trade barriers will tend to impact the

U.S. dollar. The continued existence of various trade barriers in many countries may keep the

demand for U.S. exports weaker than it otherwise would be. The lowering those barriers

significantly will boost the demand for U.S. goods and services; it would also exert some

upward pressure on the dollar exchange rate.

6.0 CONCLUSION

Conclusively, depreciation of U.S dollar value has greatly influences on the U.S economy in

general and other countries as well either it are detrimental or beneficial impact. It depends on

the country how to make use of the fluctuation of U.S dollar and turn it to advantage to its

economy. The accumulative of factors which include trade deficit versus the U.S dollar index,

housing bubble, size and liquidity of asset markets, interest rates, currency pegs, market

psychology, inflation, and gold fundamentals has cause the fluctuation of U.S dollar over the

years.

Since of the high level of international economic combination, or trade between

different countries, U.S dollar are sure affected by many things. This means that U.S and other

countries’ policies and economies circumstances have an impact on the fluctuation of the U.S

dollar. Depreciation of U.S dollar overall makes the U.S manufacturers happy, since exports

made with cheaper dollars can be sold to overseas for more profit. However, the Asian

economies are suffering from weaker economic growth and sharp decline of their export

activities because of the fluctuation of U.S dollars.

22

United State government had taken a few policies to constrict the fluctuation of dollar.

The U.S Treasury and Federal Reserve often synchronize policies that affect dollar exchange

rate. One of the policies is government direct intervention in the Foreign Exchange Market.

Secondly is monetary policy. To strengthen the U.S dollar, it has to tighten the monetary policy.

Moreover, fiscal policy and Federal debt are one of the policies. Government’s spending, taxing

and budget deficit will influence on the economy. Lastly is a lowering foreign trade barrier will

increase the demand for the U.S goods and services.

To have deal with the fluctuation of the U.S dollars, there is way that is Eurodollar.

Euro could be merging with the dollar and would act as a single currency for United States and

Europe. This might decrease the fluctuation of U.S dollar. Eurodollar would produce economic

benefits. Eurodollar as single currency makes economic transactions easier than having

different currencies for the union. Investors who want to invest in foreign country can save their

transaction cost because they do not have to convert money from one currency to another.

Moreover, Eurodollar would support international trade and lessen the disruptions that result

from the currency fluctuations.

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