USD demand and supply

Indian Investor Says: September 6, 2009 at 9:01 am | Reply edit Talking of real exchanges, the US hasn’t had a trade surplus with any of its top 30 trading partners in the last 30 years. If you go to a Wal-Mart there, you notice that radios, shirts, computers, etc – everything real has been imported. In India there’re millions of people employed in IT and BPO sectors that provide services to the US. If exchange rates are derived from real exchange of goods and services, the USD should be one of the weakest currencies in the world, shouldn’t it? So all we have is inflows of capital to USD denominated securities, that kept the USD as one of the strongest surrencies in the world. How does this system work? And I don’t see your solution yet to my query as to what determines the upper limit on Government spending on public works.

The value of the dollar is, we are told. dependant on the supply and demand for it.  The demand for it comes from not just trade flows (current account), but also demand on the capital and financial account.  In the early days of the balance of payments, trade flows were predominant, and trade credits were the accompanying entry on the capital account.  It made sense in those days to talk of the current account balance, and draw the line below it.  Whatever came under the line was financing for the deficit above the line.

But today there are many autonomous flows on FDI account (financial account), potfolio investment account (financial account) etc that it doesn’t make much sense to talk of the trade deficit.  Remember that there is worldwide a demand for USD as an asset to hold, against the possibility of local currency depreciation.

Thus the demand for the USD is not a simple transactions demand.

On the supply side, the US has been expanding excess reserves of the banking system at a tremendous rate.  When those dollars are lent out, there will definitely be an excess of supply in the market (for eurodollar) and the currency should weaken.

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