[Zygote]

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I realize that it is all about supply and demand (just like any other stock), but upon further reflection I think my problem is that if the dollar falls X% versus another currency, does that mean investors have X% less faith the U.S. will be able to pay back its debts and/or remain financially stable?


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This only means the short term sellers outweigh the buyers, with respect to the dollar versus the other currency. How you interpret this relative to overall currency confidence isnt necessarily implied. If the dollar falls perpetually, versus all things the dollar can purchase, however, this would be an almost definite sign of loss in dollar confidence versus all other assets.

Also, the dollar falling against one currency may be strength in that currency rather than underlying weakness in the dollar compared to assets other than that currency pair. In a way you could say short term confidence resides higher with the specific appreciating currency relative to the non-appreciating currency, but this doesnt automatically imply anything substantial about the non-appreciating currencies overall confidence.

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This has confused me as well. I understand that if the interest rate increases, investors will become more interested in the dollar because they will make more money.

But doesn't this mean that the federal government will just have to pay back more money down the road, further eroding confidence in the dollar?


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National commercial banks borrow cash and assets from each other to cover shortfalls in their trade flow and therefore reserves. Banks that save and are compensated provide the reserves for those that borrow and pay interest. When the banks start charging a rate of interest above the fed funds rate, because the banks lose confidence at the old yield rate of loans, the fed will inject cash into bank reserves until the rate they charge comes down to the feds target. If the rate falls below the fed target they will withdraw reserves.

When the fed is persistently injecting cash to maintain artificially low rate then the currency will be severely hurt because these reserves are created out of air and heavily expanded by the banks through the credit multiplier effect as cash goes from bank to bank each with small reserve requirements creating more and more credit in the process. Anyone owning dollar denominated assets, including bond holders, now face greater risks relative to the yield they accepted on a security since the dollars they get paid back in will have decreased purchasing power. This will start to crunch credit markets and what they've financed as the cost of borrowing rises. This means interest yields will be driven up, assuming there aren't major foreign political repurchases and the fed has run out of steam.

It means the economy will have to slow down. The society will need to focus on savings and getting out of debt. There will be higher interest paid on loans but thats the price of borrowing when you have bad credit. Thats the only way to get loans. Hopefully this will encourage the economy to stop borrowing, slow down on consumption and spending, get back to producing and then they will be on an effective path.

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Without raising taxes or reducing government spending, would raising interest rates be harmful in the long run to the dollar?

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Raising interest rates is positive for the dollar relative to the previous position in the long run since savings is more rewarded and therefore likely in more demand.