Introduction the U.S war against Vietnam. The constant

Introduction and discuss question.

Exchange rate is an important element in measuring a countries proportional level of economic health along
with factors such as interest rates
and inflation. Exchange rates have played and continue to play
a vital role in a countries balance of payments (exports-imports) the
figures presented in the balance of payments are
vital to a large number of free market economies, including the two biggest economies in the
world- USA and China.

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This essay will explore the theoretical framework of
exchange rate determination, an analytical review of the performance of the U.S
economy (post 2007/8) and the vitality of the dollar as a reserve currency a brief analysis
at the role of the current
account deficit weigh on the dollar. Succeeding
this an analytical review
of china’s economy and economic
performance. The causes of the trade deficit
being due to US competitiveness problems. Finally, the question
is asking to explore the future
of the USA dollar and international
reserve currency.


The Bretton Woods System (fixed exchange rates) was abolished by U.S president Nixon during 1971-1973. The system was abolished due to unsustainable increases in money supply to fund for the U.S war against Vietnam. The constant increase in money supply was resulted in uncontrollable inflation and to combat this problem there was a shift in economic ideology and the U.S currency changed from fixed to floating exchange rates.

Floating exchange
rates currency value
is determined by
influences such as; interest
rates, confidence, the current account
on balance of
payments, economic growth and

relative inflation




Figure 1-shift in demand for FX                                                                                            Figure
2-shift in supply of FX.






A nations demand for FX is derived from; corresponds to the debit
items on the nations balance of payments. Supply of foreign
exchange refers to the amount of foreign
exchange that will be offered to the market at various
exchange rates. (J, Carbaugh.

Equilibrium in the foreign exchange market occurs were S-D intersect. Due to the
highly competitive nature of floating currency values which are determined by unregulated forces so long as central banks do not
attempt to stabilise them foreign exchange there are large numbers of buyers and
sellers and as a result of this
it is unlikely that the equilibrium exchange rate remains for long periods of
time therefore we should witness shocks in supply and demand S1-S2, D1-D2. Equilibrium exchange rates in foreign markets are
determined by market forces.


Free capital flows refer to the
lobbying of money for corporation production purposes, or foreign direct investment (FDI).

Free capital flows refer to the
movement of money for the purposes of business production or foreign direct investment (embracing the flow of capital within corporations in the form of investment capital, spending on operations and research and development)


The global
financial crisis (GFC) which began a decade ago left plenty of economic
and political scars Proceeding the GFC, it has
been argued that there was a combination of factors that caused the surprising
appreciation of the U.S dollar during the second half of 2008. The first factor
being the global flight to safety into US Treasury bills (AAA rating) as well
as the reversal of carry trades during the crisis were all sources of keeping
the strength of the U.S dollar. Furthermore, the surge in dollar funding costs
in the interbank and the FX swap markets provided price incentives for
corporations to draw on non-dollar funding to pay down existing dollar debt. As
a final point, dollar asset write-downs left European banks and institutional
investors outside the U.S with over hedged dollar books (R. McCauley, P McGuire
2009). The squaring of their positions, which required dollar purchases, also
contributed to boosting the currency. (McCauley, Robert N. 2012)


The GFC reshaped
the way capital flows
around the world. In
2007, almost three times as much money crossed
borders than it did in 2016, as investors
pursuit yields and inflate
markets in a world of low interest
rates. Financial institutions which once saw rich futures in lending
overseas are staying closer
to home due to uncertainty, and more of the money that does cross
borders is in the form of long-term direct investment,
presumably to build factories
or purchasing stakes
in companies in
promising markets. Demand for the U.S dollar has remained high since the “dot-com”
bubble. Decreasing interest rates to low levels to encourage consumption and confidence.
This has aided in keeping
demand for the dollar high
in addition it remains uncompetitive internationally.

As of the
fourth quarter of 2016 (most recent report), there was $5.053 trillion in
foreign government reserves held in dollars. That is 64 percent of the total
measurable reserves. It’s down from 67 percent in Q3 of 2008. The deterioration
is a result of foreign governments moving their currency reserves out of

the U.S dollar has been held by foreign governments (increased demand from
emerging market economies) in their currency
reserves.  These foreign governments
build up stocks of dollars as they export more than they import. They receive
dollars in payment. Many of these countries find that it’s in their best
interest to hold on to dollars because it keeps their currency values lower.
Among the largest holders of U.S. dollars is China.

As the dollar declines, the value of their reserves also
decreases. As a result, they are less willing to hold dollars in reserve. They
diversify into other currencies, such as the euro or even the Chinese yuan. This reduces the demand for the
dollar. It puts further downward pressure on its value.( K. Amadeo, 2017)


Both the global flight to safety
into US Treasury bills (AAA) and the reversal of carry trades amidst the crisis
were sources of dollar strength. In addition, the surge in dollar funding costs
in the interbank and FX swap markets provided price incentives for corporates
to draw on non-dollar funding to pay down existing dollar debt


Historically, U.S goods have never been price competitive due to strong exchange rate. The U.S goods market has always been in a trade deficit however the services sector is in surplus. In theory devaluing the exchange rate due to not
earning enough from exports should result in U.S good becoming more competitive (ceteris paribus). Since 2008 we have
seen since
that this has not been the case, due to emerging economies demanding more
dollars to purchase in the bond market

Currently US has had a trade deficit. Not earning enough from exports. US $ Exchange Rate should decline. This will make US goods competitive again. 


In 2016 the total trade deficit in the
U.S was -$502bn. This
is due to the U.S having imported goods and services worth $2.712 trillion whilst exporting $2.209 trillion. The dollar had strengthened by 25% in
2014 and
in 2015 which means imports are cheaper for U.S consumers and exports are dearer for emerging economies or developed economies. Therefore, the
deficit in 2016 was significantly higher than it was
in 2013 when it was $478bn.

But the deficit is less than the record $762 billion in 2006. The decrease since then means U.S. exports are growing faster than imports.

FX reserves refer to
assets which are controlled
by the monetary
authority in an
economy, they are
usually various reserve currencies.
The main purpose
of holding foreign exchange reserves is to
make international
payments and hedge
against exchange rate risks.

The demand for Treasury securities coupled with the deficit spending needed to finance the
Vietnam War and the Great Society domestic programs caused the United States to flood
the market with paper money. With growing concerns over the stability of the
dollar, the countries began to convert dollar reserves into
gold. The demand for gold was such that President Richard Nixon was forced to intervene and
delink the dollar from gold, which led to the
floating exchange rates that exist today.


A current account deficit means
the value of exports
is less than that of imports.
If, however, the deficit
is financed by
a surplus on
the capital account then
it is regarded
satisfactory. Nevertheless, when an economy
struggles to entice enough
capital inflows to finance
a current account
deficit will should witness
a depreciation in
the currency value (J,
Carbaugh 2009).

Current account in balance of payments refers to the monetary value of international
flows associated with transactions
in goods and services, investment
income and unilateral transfers.

The current account relationship to total savings
and investment is an identity, which means that it does not tell us why the U.S
economy runs a current account deficit.


The left and right sides are equal by definition.

dollar value of merchandise exports is recorded as credit, and
the dollar value of merchandise imports is recorded as a debit. When
the merchandise trade balance is negative the result is a merchandise trade deficit; a
positive balance implies merchandise trade surplus.

The trade deficit in the U.S has been on a continuous increase since the 1990’s
and has been growing incessantly until the outbreak of the financial crisis. During
the period of the increase in the deficit emerging economies were witnessing rapid economic growth, during
this period asset prices and debt both amplified rapidly. Resulting
from the 9/11 attacks
the U.S economy faced a stock market bust in which the FED decreased interest rates to boost economic activity. The
reduction in interest rates during this period was sufficient to increase growth due to high animal spirits and growth of emerging economies.

An increase in house prices and household debt led to unprecedented
levels of personal savings plumped and imports exploded, culminating
in the financial crisis which began in 2007 with
the collapse of the Lehman Brothers bank.

With a trade deficit, the
value of the dollar may fall in international
currency markets as dollar out payments exceed dollar in payments. Foreign
currency would therefore become more expensive in terms of dollars, as
a result imports would become dearer for U.S residents.

A trade deficit that induces a decrease in the dollar’s international value imposes a real cost on U.S residents in the form of higher import costs. A worsening trade balance may injure domestic labour markets, when a nation’s trade deficit which results in decreased employment in some industries may be offset by capital and financial account inflows that generate employment in other industries. The discussion based on the U.S competitiveness in merchandise trade gives the impression that the U.S has consistently performed poorly relative to other industrial nations.

If a current account deficit is financed through borrowing it is said to be more unsustainable. This is because borrowing is unsustainable in the long term and countries will be burdened with high-interest payments.

Countries with large interest payments have little left over to spend on investment…EXPLORE USA BORROWING FROM CHINA


A Balance of payments deficit may cause a loss of confidence by foreign investors. Therefore, there is always a risk, that investors will remove their investments causing a big fall in the value of your currency (devaluation). This can lead to a decline in living standards and lower confidence for investment.

2010 the
global financial crisis conveyed inherent weaknesses in the
international monetary system that contributed to the
global financial instability, this occurred soon after the global economic crisis and during a period the
world economy was weak.

emerging economies such as china,
which rely heavily on international foreign direct investment for
growth and their economic development, the failure of the
current global reserve system in ensuring that
sufficient international liquidity causes them to suffer from
negative spill overs of the
global financial instability and economic growth,

As the U.S dollar is used as an international reserve currency, instead of gold reserves, other countries accumulated reserves of U.S. dollars. Needing a place
to store their dollars, countries then began to purchase U.S. Treasury securities, which are considered to be a safe store of money
or the safest store with a AAA

As emerging economies continue to grow, demand for international reserve assets increase with international incomes and trade. à

The reserve currency must then continue to meet
the growing demand for the currency. While surplus country could be bale
to accumulate reserves while the outstanding external debts of the
international reserve issuing could rise and this may cause investors to lose
confidence in the value of reserve assets. There
is no mechanism of forcing surplus countries or reserve issuers to make adjustments to fix imbalances.

In recent years emerging economies demand for U.S dollar reserve currency have increased in demand. As a result of this
there is a surety against capital account crisis and because they cannot predict interest rates during the borrowing of the
reserve currency

During the balance of payments crises, international currency reserves play
an important role in reducing output loss.

For the last decade or so, china’s economy has been growing rapidly due to export led growth. The Chinese currency Renminbi (RMB) has slowly becoming a new international reserve currency. China is now the second largest economy and second largest trader which they also hold the largest amounts of foreign reserves. Chinas economy accounts for one-fifth of the incremental demands world-wide.

China’s open door policy prompted drastic economic changes that allowed China to be an economic superpower by 2008. A milestone came in December 2001, when China became a member of the World Trade Organization (WTO) (WTO 2012), which accelerated its integration with the world economy. Since then, underpinned by rapid expansions of trade and deep structural changes, its economy has continued to deliver yearly double-digit growth (R. Herd,
V. Koen and P. van den Noord, 2011-OECD report) The speed of its integration with the world economy, coupled with excess demand worldwide, pushed up China’s current account surplus to as much as 11% of its GDP by 2007. In 2007, with a trade dependency rate of 66%, China was categorized as having a very open economy by international standards (Heilmann and Schmidt 2010). This high dependency explains why China was not immune from the 2008 global financial crisis.

Following the financial crisis, thousands of private companies in China closed down due
to decline in export-led demand. In the first half of 2009, exports sank 21.8% and imports declined 25.4% (Heilmann and Schmidt 2010). The Chinese government estimated that as of 2007 there were 286,200 approved foreign-invested companies in China. Such firms employed more than 42 million people and accounted for 31.5% of gross industrial output value (Morrison 2011). With the international money market crunch, capital flight from emerging countries is a common practice

It has been argued that the dollar is over-valued and this obstructs the export sector, which has undermined exports and business investment spending. This has allowed imports to take market share from U.S manufacturers. The over-valuing of the dollar is causing long-term damage by eroding manufacturing which is a key engine of productivity growth….

According to the 2003 National Association of Manufacturing (NAM) the value of the dollar rose above the level of consistent with economic fundamentals which resulted in the over-valuing of the dollar. The dollar continued to appreciate in spite of fluctuations in economic growth, interest rates and trade balances that would have in normal situations warrant the currency to depreciate. NAM notes that the strong dollar decimates U.S manufactured goods exports, artificially stimulating imports and consequently putting thousands of American workers out of work.

The effect of over-valuing of the dollar foretells for lower future growth and living standards U.S policy makers will have to abandon the rhetoric a “strong” dollar, this rhetoric may be deemed to be sending misleading signals to foreign exchange markets. The over-valuing of the dollar makes it attractive for foreigners to purchase U.S treasury bonds due to a near certainty of return.

Currently and
historically the RMB has been under-valued and has been for the last few years. China’s government has been accused of manipulating the currency to keep it devalued due to export led growth. When U.S. president Donald Trump took office he argued that the Chinese currency manipulation resulted in U.S. goods and services being unattractive and this would be something he’d reform in office He
has vowed to
impose punitive tariffs
on its imports
into the US
in a move
economists fear
could set off
a trade war
between the world’s
two biggest economies. the RMB must therefore be revalued up.

Whether the RMB will emerge as the new global reserve currency depends upon several factors such as: economic growth, productivity, political stability and China’s trading partners.

US Treasury on Friday said that by its reckoning China now met just one of the three criteria for inclusion on a currency watch list after its current account surplus fell below 3 per cent of gross domestic product in the year to June. Under Treasury’s current guidelines that means that, if nothing changes, Beijing could fall off the watch list as soon as next year.  For their twice yearly foreign exchange report to Congress Treasury officials also monitor a country’s trade balance with the US as well as any “persistent one-sided intervention” in currency markets.  The US goods trade deficit with China was $356bn in the year to June and remains the largest of any with US trading partners, though it was down from $363bn for the 12 months to June 2015. The US also had a $35bn surplus in services trade with China in the year to June 2016. 
But the trade deficit was the only criteria that qualified it for inclusion on the watch
list. To remain on the list countries, have to meet two of the three criteria, although under Treasury’s rules any country included must remain on the list for two consecutive six-monthly reports afterwards. 
China’s forays into currency markets had actually been to the benefit of other big economies over the past 18 months as they had taken place to stop a potentially disruptive devaluation of the renminbi, treasury economists reported. 

Altogether Beijing had sold more than $570bn in foreign exchange assets in the year to August 2015. to slow the depreciation of the RMB, the US Treasury calculated. The RMB had fallen by 6.9 per cent against the dollar since August 2015, when the People’s Bank of China announced it would allow the currency to trade more freely, the Treasury said, but was still up 21 per cent against the dollar since December 2005. 

The U.S Treasury said that its analysis had concluded that no major trading partner of the US was now manipulating its exchange rate with the dollar in order to prevent any balance of payments adjustments or gain an unfair competitive advantage in international trade. 

In 2016, the
total U.S. trade deficit was $502 billion. That’s because it imported $2.712 trillion of goods and services while exporting $2.209 trillion. The deficit is higher than
in 2013 when it was $478 billion. That’s because the dollar strengthened 25 percent in 2014 and 2015. (K. Amadeo, 2017)

But the deficit is less
than the record $762 billion in 2006. The
decrease since then means U.S. exports are growing faster than imports. (K. Amadeo, 2017)



Overall, economically if China continues to grow at the rate it is and increasing its trade partners


For a
country with a
budget deficit in
excess of $1 trillion
a year, the
consequences of losing standing
as the world’s reserve currency would be
dire. … “If the dollar loses status as the
world’s most
reliable currency the United
States will lose the
right to print
money to pay
its debt (J. Cox 2013).
In August 2015 — Beijing has spent billions of dollars in
recent years propping the renminbi up, not pushing it down The US could always
argue the Chinese currency should be allowed to float completely free of state
intervention. But it is obviously not in America’s interest to see a sharp
appreciation against its largest trading partner and risk a destabilisation in
the global financial system. In any case, naming China a manipulator, contrary
to the over-excited threats of some currency warriors, authorises the US to do
nothing except negotiate with Beijing over the renminbi, which it is already