Monetary Policy and the Dollar?s Depreciation

The dollar has been depreciating in foreign-exchange markets since February 2002. But in early 2006, the underlying nature of the dollar’s descent changed. Prior to that time, an expanding U.S. aggregate demand seemed to have provoked the dollar’s decline, but thereafter, the diversification of international investors’ portfolios away from dollar-denominated assets seemed to be the cause. This diversification and the associated depreciation can affect the U.S. macroeconomy along at least three key dimensions: trade, prices, and interest rates. For that reason, the sharpness and protracted nature of the depreciation have started to raise questions about possible implications for U.S. monetary policy and about possible policy responses to the dollar’s fall.