Between July 1995 and February 2002, the dollar’s value rose nearly 50 percent in comparison to a handful of other major currencies.² But in six months — from January to June 2002 — the dollar lost 7.8 percent of its value against the major currencies.³

What caused the dollar’s recent decline, and what does it mean to the nation’s economy? Some immediate side effects are readily predictable, but the long-term impact is more difficult to foresee.

Foreign Investors Make a Move
A nation’s economic strength and stability contribute largely to the value of its currency. And when investors send more money into the country than they take out, the currency becomes stronger. In the late 1990s, when the U.S. economy was in expansion, foreign investors poured money into the economy at a rate of $1 billion a day.⁴ In doing so, they banked not only on the strength of the U.S. financial markets but also on the strength of the dollar.

Today, foreign investors hold 40 percent of U.S. Treasury bonds, 24 percent of U.S. corporate bonds, and 13 percent of U.S. equities.⁵ Their faith in the American economy has helped propel the dollar’s value in the last several years, despite periods of economic uncertainty and low interest rates.

But a slow economic recovery — made more fragile by threats of terrorism, the corporate accounting controversy, and disappointing stock market returns — has caused many foreign investors to question the dollar’s resilience. In search of higher returns and more favorable exchange rates, many have cashed in their dollars and moved their money to Europe and other economies that appear to be recovering from recession more quickly than the United States, such as Australia, Canada, Thailand, and South Korea.⁶ The resulting surplus in dollars has helped weaken the currency’s value.

Weak Dollar Could Help Some, Hurt Others
Although a “weak” dollar may not sound promising, it could strengthen certain sectors of the economy. American manufacturing and farming products will become less expensive overseas, helping those businesses to become more competitive in foreign markets. It may also allow these companies to sell more in the United States if imported goods and services become more expensive.

A declining dollar could result in higher inflation. Companies that rely heavily on imports must pay more for the same amount of foreign merchandise. If they try to pass the price increase along to consumers, buyers may look for substitutes.

In the months ahead, the dollar’s value will be influenced by a variety of factors, including reports on the economy’s strength and actions by the Federal Reserve. Careful analysis is key to understanding the dollar’s movements and how the dollar’s volatility will influence financial markets.

1) The Columbia World of Quotations, 1996
2, 4–6) The Wall Street Journal, June 3, 2002
3) The New York Times, June 20, 2002