[Excerpt] 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, 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.
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.