Top Economic Factors That Depreciate the US Dollar

Top Economic Factors That Depreciate the US Dollar

By James Mcwhinney Updated January 02, 2022  Reviewed by Thomas J. Catalano

Currency depreciation, in the context of the U.S. dollar, refers to the decline in value of the dollar relative to another currency. For example, if one U.S. dollar can be exchanged for one Canadian dollar, the currencies are described as being at parity. If the exchange rate moves and one U.S. dollar can now be exchanged for 0.85 Canadian dollar, the U.S. dollar has lost value relative to its Canadian counterpart and has therefore depreciated against it.

A variety of economic factors can contribute to depreciating the U.S. dollar. These include monetary policy, rising prices or inflation, demand for currency, economic growth, and export prices.

KEY TAKEAWAYS

*Currency depreciation, in the context of the U.S. dollar, refers to the decline in value of the dollar relative to another currency.

*Easy monetary policy by the Fed can weaken the dollar when investment capital flees the U.S. as investors search elsewhere for higher yield.

*Declining economic growth and corporate profits can cause investors to take their money elsewhere.

Monetary Policy

In the United States, the Federal Reserve (the country’s central bank, usually just called the Fed) implements monetary policies to either increase or decrease interest rates. For example, if the Fed lowers interest rates or implements quantitative easing measures such as the purchase of bonds, it is said to be “easing.” Easing occurs when central banks reduce interest rates, encouraging investors to borrow money. Those borrowed dollars eventually get spent by consumers and businesses and stimulate the U.S. economy.

However, the implementation of what is known as “easy” monetary policy weakens the dollar, which can lead to depreciation. Since the U.S. dollar is a fiat currency, meaning that it is not backed by any tangible commodity (gold or silver), it can be created out of thin air. When more money is created, the law of supply and demand kicks in, making existing money less valuable.

Also, investors often seek out the highest yielding investments, meaning the highest interest rates. If the Fed cuts rates, U.S. Treasuries, which are bonds, tend to follow suit and their yields fall. With lower rates in the U.S., investors transfer their money out of the U.S. and into other countries that offer higher interest rates. The result is a weakening of the dollar versus the currencies of the higher-yielding countries.

Inflation

Inflation is the pace of rising prices in an economy. There is an inverse relationship between the U.S. inflation rate versus its' trading partners and currency depreciation or appreciation. Relatively speaking, higher inflation depreciates currency because inflation means that the cost of the goods and services are rising. Those goods then cost more for other nations to purchase. Rising prices can decrease demand. Conversely, imported goods become more attractive to consumers in the higher inflation country to purchase.

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