Teaching Note The Falling Dollar: Case Synopsis

Teaching Note
The Falling Dollar
Case Synopsis
The dollar’s role as the most important currency in the world is under attack. The dollar
has fallen dramatically in recent years against several key currencies including the euro
and the yen. Now questions are being raised as to whether the dollar can maintain its
position as the world’s reserve currency. A new hypothesis however, contends that, at
least for now, the dollar is safe. The theory suggests that instead of looking at traditional
factors and their influence on currency values, the global competitiveness of a nation’s
industries may be a better indicator of the value and stability of a currency.
Suggested Position in Course
This case provides the opportunity to take discussion of the international monetary
system and the foreign exchange market into more depth. In addition, it can be used to
expand discussion of differences in political economies and also, globalization.
Learning Objectives
After completing this case, students should be able to:
• Understand how reserve currencies are determined.
• Appreciate how a budget deficit influences the value of a nation’s currency.
• Appreciate how a current account deficit affects the value of a country’s currency.
• Understand the interconnectedness of the global monetary system.
• Be familiar the role of central banks in the global monetary system.
• Understand the notion of a pegged currency and the rationale behind it.
Case Questions
1. Describe what has occurred to the value of the dollar since it emerged as the world’s
most important currency. What factors have contributed to the dollar’s fall in recent
years? Is the dollar era drawing to a close? Could the euro take its place?
2. Comment on the hypothesis that a country’s currency reflects the country’s global
competitiveness. Do you think the dollar can retain its reserve currency status? Why or
why not?
3. How do monetary policies in other nations such as those in the emerging Asian
economies affect the value of the dollar? What does this indicate about the global nature
of the foreign exchange markets?
Case Analysis
1. The dollar initially emerged as the world’s most important currency after World War
II, and since then, has maintained that position. Now however, the credibility of the
dollar is under fire. In the last three years alone, the dollar has fallen 33 percent against
the euro, and 24 percent against the yen.
Various structural problems in the American economy have contributed to the dollar’s
slide. Government borrowing has been high, consumers appear to have an unlimited
appetite for spending, and the country has a huge current account deficit. The current
account deficit has been of particular concern. In 2004, the current account deficit was
almost twice as big as it was in the late 1980s and early 1990s. To correct the deficit, the
dollar must fall significantly-- by some estimates as much as 30 percent. This type of
correction would further undermine the credibility of the dollar. Similarly, the U.S.’
budget deficit has seen a significant negative shift. In the 1980s, the U.S. was a net
foreign creditor, but by 2004, the budget deficit was about 28 percent of GDP.
Many experts believe the outlook for the dollar is gloomy. Some are wondering whether
the dollar can retain its status as a reserve currency. The euro has already emerged as a
possible contender for the dollar’s position. According to The Economist, the
requirements of a reserve currency are a large economy, open and deep financial markets,
low inflation, and confidence in the value of the currency. Thus, one could make the
argument that since the euro zone area’s economy is nearly the same size as that of the
U.S, the euro zone is the world’s largest exporter, and the euro zone has deep and liquid
financial markets, the euro could be a viable alternative to the dollar.
2. The case raises the notion that a nation’s currency is an indicator of the country’s
global competitiveness. Accordingly, during a strong economic period, the currency will
be credible. This theory discounts the influence of some traditional indicators of
currency value like the size of trade deficits and budget deficits. Instead, it focuses on the
global competitiveness of a nation’s industry.
Using this hypothesis, one would expect the dollar to retain its position as the most
important currency in the world. The U.S. is still considered to be the leader in high-tech
industries, and in an era of services, is also a global leader of services. U.S. industries
have also capitalized on lower labor costs by outsourcing to countries like India in an
effort to maintain their global competitiveness. In addition, because excess capacity
exists in the U.S., inflation is unlikely, minimizing the threat of the country’s large
budget deficit.
While the possibility of the euro becoming the world’s reserve currency has been raised,
this hypothesis would suggest otherwise. In contrast to their American counterparts,
Germany and France have resisted the idea of global outsourcing, and the savings it
brings. Moreover, the euro zone countries have lagged behind the U.S. in high tech
industries such as software, biotechnology, and microprocessors. Augmenting this
phenomenon is the fact that the best minds in the world tend to migrate to the U.S. rather
than Europe or Japan.
3. The global interconnectedness of the foreign exchange markets is clearly illustrated by

how events in one country have ramifications for other nations.
Many emerging economies, especially those in Asia follow a policy of pegging their
currencies to the value of the dollar. The process involves each nation’s central bank
purchasing dollars as a means of keeping their currencies low. The lower currency
values then contribute to the competitive nature of their exports. Because the domestic
money supply of the these countries grows as a result of the dollar purchases, real estate
prices, and share prices around the world rise, thus creating the potential for a pricing
bubble.
The credibility of the dollar is also undermined by concerns that the central banks in
China, Indonesia, and Russia could reduce their purchase and/or holdings of American
Treasury bonds and/or reserve dollars. Such a move could spell major trouble for the
dollar because a reserve currency is defined to be the currency in which foreign countries
like to hold their foreign exchange surplus. If central banks unload some of their $2.3
trillion of dollar assets, the dollar could collapse. Already, the dollar share of global
foreign reserves has fallen from about 80 percent in the mid-1970s to just 65 percent
today.

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Teaching Note

The Falling Dollar

Suggested Position in Course

After completing this case, students should be able to:

• Understand how reserve currencies are determined.

• Appreciate how a budget deficit influences the value of a nation’s currency.

• Understand the interconnectedness of the global monetary system.

• Be familiar the role of central banks in the global monetary system.

3. The global interconnectedness of the foreign exchange markets is clearly illustrated by

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