Why A Shrinking Trade Deficit Will Drive Down the U.S. Dollar

In a speech given on November 19th 2004, Federal Reserve Chairman Alan Greenspan made the following remarks:

"It seems persuasive that, given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point." (Source: Yahoo News)

This statement caused the value of the U.S. Dollar to fall on international markets. But what does the size of the current account deficit have to do with exchange rates?

The Current Account and Exchange Rates

The Economics Dictionary defines the current account as follows:

The current account balance is the difference between a country's savings and its investment.

The current account deficit per day in the United States is $1.8 billion dollars, meaning that Americans spend $1.8 billion more dollars abroad than come into the country each day.

What Would Happen if the Current Account Deficit Was Reduced?

If the current account deficit were to be reduced, it would be because foreign investors would no longer be willing to accept U.S. Dollar denominated debt, which is being used to finance the current account deficit. This would cause the current account deficit to shrink as foreigners would be less willing to sell goods to Americans in exchange for U.S. Dollars. If foreigners decide they do not want to hold any more U.S. Dollars, the exchange rate will fall, as with anything else, if the demand for a good goes down, so does its price. So a falling U.S. trade deficit would lead to falling demand for the U.S. Dollar, leading to a depreciation of the U.S. dollar on foreign exchange markets.

But the Current Account Deficit hasn’t Fallen Yet – Why is the U.S. Dollar Falling Already

The reason is simple: Investors are selling off the U.S. Dollar as they believe it will be worth less in the future. If you had a stock in your portfolio that you were quite certain was going to fall in value, the prudent thing to do would be to try and sell before that fall takes place. The same thing takes place on the foreign exchange market, as currency investors start to sell off their U.S. Dollars before the value of the U.S. Dollar declines. This increase in people supplying U.S. Dollars for sale acts to drive the price of the U.S. Dollar down. The belief that the U.S. Dollar will be worth less in the future makes the U.S. Dollar worth less today.

What Does a Falling U.S. Dollar Mean to Me?

If you’re in the United States, it means that goods from other countries, such as Canadian maple syrup, will become more expensive as the Canadian dollar is now worth more relative to the U.S. one, as we saw in the article “ A Beginner's Guide to Purchasing Power Parity”. However, it also means that American goods are now cheaper in Canada, so we should see exports to Canada rise. While a falling U.S. Dollar sounds bad, if you own or work for a company that sells goods abroad, the future may be getting brighter.

If you would like to contact the Economics Guide you can do so by using the Feedback Form.