From a peak in early 2002 through the first half of 2008, the (inflation adjusted) trade-weighted dollar exchange rate, for the most part, steadily depreciated, falling a total of about 25% (see Figure 1 ). The dollar's fall over this six-year period was moderately paced at about 3% to 4% annually. For the next nine months, as the wider economy was reeling from the effects of the financial crisis and recession, the dollar sharply appreciated, increasing more than 11% on a trade-weighted basis. For reasons that will be discussed later in the report, this appreciation was a market response to the great uncertainty associated with those economic troubles. As economic conditions began to stabilize in mid-2009, the dollar began to depreciate again and fell about 16% through mid-2011 and more or less returned to its prerecession trend of depreciation. However, a second bout of market uncertainty caused by the European sovereign debt crisis caused the dollar to appreciate more than 5% through the end of 2011. In early 2012, the dollar resumed its depreciation, down about 2% through February 2012 and, with the return of some degree of financial normalcy in Europe, the trend depreciation some believe may resume. The dollar's fall from early 2002 through early 2008 as well as the recent depreciation has not been uniform against individual currencies, however. For example, in the earlier period, it fell 45% against the euro, 24% against the yen, 18% against the yuan, and 17% against the Mexican peso. In the period since the trough of the business cycle in mid-2009, the dollar fell 13% against the euro, 11% against the yen, less than 3% against the yuan (all of which occurred recently), and 8% against the peso. These differing amounts of depreciation are partly a reflection of the countries' willingness to let their currencies fluctuate against the dollar. The euro is free floating, the yen has been moderately managed (mostly before 2005 but more deliberately since September 2010), and the yuan is actively managed (its value rigidly fixed to the dollar before 2005 and from mid-2008 until mid-2010; since then allowed to rise moderately against the dollar). But the pattern also reflects significant structural asymmetries in flows of global assets and global goods, as well as differences in business cycles, inflation rates, shocks affecting the different economies, and an unwinding of imbalances that were present in 2002. The weakening of the dollar raises concern in Congress and among the public that the dollar's decline is a symptom of broader economic problems, such as a weak economic recovery, rising public debt, and a diminished standing in the global economy. Have recent policy actions such as quantitative easing by the Federal Reserve (Fed) and fiscal stimulus passed by the 111 th Congress had an effect on the dollar? How might failure by the 112 th Congress to raise the federal debt ceiling or address the country's long-term government debt problem affect the exchange rate? Is there a positive side to dollar depreciation? Economic theory suggests that the dollar's path can be influenced by a variety of factors that could confer to the United States both benefits and costs, and in some circumstances a depreciating currency can be, on balance, beneficial. This report examines the several factors that are likely to influence the dollar's medium-term path; why further depreciation could occur; what effects a depreciating dollar could have on the economy, including the pace of economic recovery; and how alternative policy measures might influence the dollar's path. Since the break-up of the Bretton Woods international monetary system in 1973, the exchange rate of the dollar has been largely determined by the market—the supply and demand for dollars in global foreign exchange markets. Dollars are demanded by foreigners to buy dollar denominated goods and assets. (Assets include bank accounts, stocks, bonds, and real property.) Dollars are supplied to the foreign exchange markets by Americans exchanging them for foreign currencies typically needed to buy foreign goods and assets. Since the mid-1990s, the United States has had a growing trade deficit in goods transactions, generating a net increase in the supply of dollars on the foreign exchange markets, thereby exerting downward pressure on the dollar's exchange rate. At the same time, the United States has had an equal-sized surplus in asset transactions, reflecting a net increase in the demand for dollars on the foreign exchange market, thereby exerting upward pressure on the dollar's exchange rate. In most circumstances, however, there is a strong expectation that asset-market transactions will tend to be dominant and ultimately dictate the exchange rate's direction of movement. This dominance is the result of gross asset-market transactions occurring on a scale and at a speed that greatly exceeds what occurs with goods-market transactions. Electronic exchange makes most asset transfers nearly instantaneous and, in most years, U.S.-international asset transactions were two to three times as large as what would be needed to simply finance that year's trade deficit. In 2007, near the peak of the last economic expansion, the U.S. capital account recorded $1.5 trillion in purchases of foreign assets by U.S. residents (representing a capital outflow) and $2.1 trillion in purchases of U.S. assets by foreign residents (representing a capital inflow). So while the United States could have financed the $702 billion trade deficit in goods and services in 2007 simply by a $702 billion sale of assets to foreigners, U.S. and foreign investors engaged in a much larger volume of pure asset trading. Economic theory suggests that several economic factors could influence the direction of cross-border asset flows. The demand for assets (e.g., bank accounts, stocks, bonds, and real property) by foreigners will be strongly influenced by the expected rate of return on those assets. Therefore, differences in the level of interest rates between economies are, other things equal, likely to stimulate international capital flows from countries with relatively low interest rates to countries with relatively high interest rates, as investors seek the highest rate of return for any given level of risk. When inflation rates among economies are similar, the average level of nominal interest rates can be used as a fairly reliable first approximation of the rate of return on an asset in a particular currency. Rates of return on dollar assets can be influenced by the general performance of the economy as gauged by its ability to sustain a high rate of economic growth and a low rate of inflation. Another potential influence on expected rate of return is the Fed's conduct of monetary policy as it periodically moves interest rates up or down to stabilize the economy. In addition, whether the United States business cycle is synchronous or asynchronous with that of other economies will influence the relative level of interest rates between it and other economies. In general, these relatively short-term interest rate fluctuations will tend to either attract or deter foreign capital flows, particularly in relatively liquid assets. The rate of return advantage in the U.S. economy may be greater than the spread between market interest rates would suggest, however. A study by the International Monetary Fund (IMF) that focused on return to debt and equity capital for publicly traded companies in the large industrial economies and the developing economies for the decade 1994-2003 found the rate of return in the United States to have been about 8.6% as compared with a G-7 average of about 2.4% and an emerging market average of about minus 4.7%. Currently, the combination of substantial economic slack and highly stimulative monetary policy in the United States and other advanced economies has pushed down short-term and long-term interest rates to historically low levels and left virtually no sizable interest rate advantage of dollar assets over assets in the currencies of other G-7 economies. For example, the yields on 10-year government bonds in Germany, Canada, the United Kingdom, and the United States during 2011 have been within a narrow band of 2.5% to 3.0%. Japan, however, has been an outlier among advanced economies, with the yield on 10-year government bonds hovering slightly above 1% over this period. In contrast, many emerging economies are showing much stronger economic performance and asset yields are likely to be substantially above those in the United States and other advanced economies, which could entice many investors to move capital from the advanced economies to the emerging economies. This would exert downward pressure on the currencies of the advanced economies, including the dollar. Whether a currency's exchange rate will rise or fall in the future can figure prominently in some investors' calculation of what will actually be earned from an investment denominated in another currency. If, for example, the dollar depreciated on average 4% annually for the next several years, then the 2% to 4% average nominal interest rates currently attached to low-risk medium- to long-term U.S. securities would offer the foreign investor an expected return of approximately zero or less. (If the expected currency depreciation were greater, the investor would expect to incur a capital loss.) In general, expected dollar depreciation lowers the expected return and reduces the attractiveness of dollar assets to the foreign investor. On the other hand, if the exchange rate is expected to appreciate, the expected gain would be greater than the nominal interest rate attached to the security, making that asset more attractive. Investor expectations will, therefore, tend to act as an accelerant, adding momentum to the exchange rates movement, whether up or down. At the extremes this could be destabilizing, generating sizable over-valuations or under-valuations of a currency. The dollar's long and generally orderly depreciation between 2002 and 2008 suggests investor expectations about the currency's path did not act as a destabilizing factor.