Profile of United States’ Dollar – Overview of Economy

Profile of United States’ dollar – overview of economy

This lesson will cover the following

  • A look at US economy
  • Monetary policy authority – the Federal Reserve Bank
  • Monetary policy tools

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Economic overview

The United States is world’s largest economic power with a nominal Gross Domestic Product (GDP) at the amount of 16.8 trillion USD in 2013. It represents almost 25% of the global nominal GDP. In terms of purchasing power parity, US GDP is also the highest worldwide, almost four times the size of Japanese output, five times the size of German output and seven times the size of United Kingdom’s output. It represents almost 20% of the global total GDP. US Gross Domestic Product at purchasing power parity per capita is the sixth largest in the world (53 101 USD as of 2013, according to data by the International Monetary Fund).

48B2DE2A-1825-4F35-B99A-BBBCD2F7FF6F_w640_r1_sUS economy is primarily service-oriented, as almost 80% of the GDP is produced by sectors such as real estate, transportation, financial services, other business services and health care. As of 2013 the United States is the third-largest producer of oil (8 453 000 barrels per day, or 9.97% of the global total oil production) and the largest natural gas producer (66.5 billion cubic feet per day).

Welder at WorkThe country is the second largest manufacturer in the world, as its industrial production was 2.43 trillion USD during 2013, or larger than output of Germany, France, India and Brazil together. Major industries are petroleum, steel, automobile production, aerospace, construction and agricultural machinery, chemicals, electronics, telecommunications. The size itself of nation’s manufacturing contributes to US dollar’s sensitivity to potential developments in the sector. United States’ manufacturing output accounts for almost 18% of the global manufacturing production.

US FDIAs the country has the most liquid stock and fixed income markets in the world, this has lured consistently increasing investments from abroad. Foreign Direct Investment (FDI) in the United States, evaluated on a cumulative stock basis, climbed to 2.7 trillion USD at the end of 2012, which represents about 16% of nation’s Gross Domestic Product. FDI, which flowed into the economy in 2012 alone amounted to 166 billion USD. Net equity flows amounted to 59.6 billion USD in 2012 and 98.5 billion in 2011, while reinvested earnings increased to 105.8 billion USD in 2012 from 80.9 billion USD in 2011. It is worth noting that in case expectations of foreign investors regarding returns in US asset markets are not met, a possible repatriation of their funds would cause a considerable impact on both US asset values and the exchange rate of the US dollar. If investors reduced their possessions of US dollar-denominated assets in search of higher yields in other regions of the world, values of US assets would decrease, while this would also devalue the dollar.

container ship docksThe United States is the second largest trading nation in the world, following China. About 60% of all funds circulating globally as a result of international trade are US dollars. US exports amounted to 2.27 trillion USD in 2013, while imports were at the amount of 2.74 trillion USD. Trade in services produced a surplus of 231 billion USD, while trade in goods produced a deficit of 703 billion USD in 2013. In Q3 2013 the deficit on nation’s current account was the least since Q3 2009, shrinking to 94.8 billion USD from a deficit figure of 96.6 billion USD during the second quarter of 2013. The Q3 deficit represented 2.2% of the GDP. Large current account deficit is a problem, which US economy has been facing for over a decade. A huge deficit on country’s current account makes the national currency extremely sensitive to changes in capital flows.

The United States is the largest trading partner for a number of countries worldwide. This is an extremely important ranking, because possible changes in the value of the US dollar will certainly have an impact on United States’ trading relations with these countries. A weaker national currency would benefit US exports to its partners, while a stronger currency would obstruct demand for US exports abroad. According to CIA World Factbook, in 2012 the main export partners of the United States were: Canada (292.8 billion USD or 18.9%), Mexico (216.3 billion USD or 14%), China (110.6 billion USD or 7.2%) and Japan (70 billion USD or 4.5%).

At the same time, in 2012 the main import partners of the United States were: China (425.6 billion USD or 19%), Canada (324.2 billion USD or 14.1%), Mexico (277.7 billion USD or 12%), Japan (146.4 billion USD or 6.4%) and Germany (108.5 billion USD or 4.7%).

These rankings are vital, as they also represent how important for the United States economic development and political stability of these nations are. In case economic growth of Canada decelerated, Canadian demand for US exports would be diminished and this would have an unfavorable effect on US economy.

Monetary policy authority – the Federal Reserve Bank

The-US-Federal-Reserve-007In the United States the Federal Reserve has the responsibility to set and implement monetary policy through the Federal Open Market Committee (FOMC). The members, who have the right to vote, are the seven governors of the Federal Reserve Board and five presidents of 12 district reserve banks. The central bank officials conduct eight policy meetings every year, with investors paying very close attention to them for changes in borrowing costs or economic growth forecasts.

In order to navigate its monetary policy the Federal Reserve Bank uses a number of tools – reserve requirements, open market operations and the base interest rate (federal funds rate).

Reserve Requirements

The Federal Reserve has set three levels of reserve requirements, based on the dollar amount of net transaction accounts held with the depository institutions. They are set as follows:

– institutions with net transaction accounts totaling less than $12.4 million are required to keep 0% as reserves;

– institutions with total net transaction accounts amounting to between $12.4 million and $79.5 million must keep reserves of 3%;

– institutions holding more than $79.5 million in net transaction accounts are obligated to have a liquidity ratio of 10%.

When taking a look at the level of change the Federal Reserve has introduced into the exemption amount and low-reserve tranche in the past 25 years, one will notice that central bank officials have been steadily increasing them, but at a minor and gradual pace in the years before the Lehman Brothers collapse in order to avoid short-term disruptions. During these 20 years, the altered ratios had an overall mixed effect on the total amount of reserves held in the system.

Since the bankruptcy of Lehman Brothers, which marked the beginning of the late 2000-s global financial crisis, the Federal Reserve has been lifting both the exemption and low-reserve tranche amounts by a larger degree. These increases have ultimately been reducing the overall amount of reserves required in the system by shifting the weight from smaller onto bigger institutions.

Open Market Operations

Open market operations generally refer to those operations by any central bank, which either increase or decrease the money supply. For more discussion on effects on economy caused by these operations and Fed’s practice in particular, visit our Forex Trading guide.

Base Interest Rate (Federal Funds Rate)

3d diceIt represents the borrowing rate, which the Federal Reserve proposes to member banks. In order to avoid excessive inflation, the central bank will usually raise its base interest rate and in order to stimulate economic growth and consumer spending, the Fed will lower this rate. Changes to the federal funds rate suggest major changes in bank’s monetary policy course and usually have considerable influence on the foreign exchange, stock and fixed income markets. The statement, released by the Federal Reserve, is another closely watched event by market players, as it may hint future actions on monetary policy.

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