Economics continues to baffle me. To be more precise, it is the part that has to do with international trade. I keep reading that:

A. The American economy is being subsidised by the rest of the world.
B. Some people want a stronger dollar
C. Some people want a weaker dollar
D. Domestic interest rates in the U.S. would rise if the value of the dollar falls.

I have taken a course in economics in college, but I am still not able to grok the above statements. So I decided to devote some time and clear things up once and for all. First, I'll list some 'axioms':

1. Countries need dollars. They need dollars for two reasons: a) to buy stuff from America and b) to accumulate them for buying stuff from other countries (the dollar is the de facto medium of transaction all over the world for various reasons)

2. A country does not simply hoard the dollars it accumulates. It invests these dollars.

3. A country's exporters benefit if the value of the dollar increases because they can earn more equivalent local currency units.

4. A country's importers benefit if the value of the dollar decreases because they need to spend lesser local currency units to import stuff from America.

So far so good. Now I'll see how I can derive theorems A-D from these axioms.

Theorems B and C are polished off straightaway by axioms 3 and 4. In addition, the European Union would like to see the Euro become an alternate medium of transaction for international trade, so I guess they would like to see a weaker dollar, too. (BTW, I am not addressing the desires of large sections of the world's population who want to see the dollar fall simply because they would like America brought to its knees).

Moving on to the other theorems, one of the avenues of investment for a country's dollars is America itself. Since the American government is living beyond its means, i.e. it is spending more than it earns, it floats treasury bonds (which are nothing but promissory notes) to finance its deficit. Other countries use their dollars to buy these bonds, in effect loaning money to the American government. This additional money is pumped into the American economy. The availability of additional money makes credit easier, thereby bringing down the interest rates. Conversely, interest rates would rise if other countries do not buy treasury bonds [*]. This proves theorem D, if we manage to show that other countries would dump their dollars if the value of the dollar falls.

Is it a truism that people will dump dollars if the dollar depreciates? I am not inclined to believe so. There are a lot of factors to keep in mind. A weaker dollar implies that exports become less competitive, which would hurt the other countries' economies. For a country to dump it's dollars, this pitfall has to be counterbalanced by some other reasons. These could be:

a) the presence of a strong Euro
b) overriding fear of dollar-denominated imports becoming cripplingly expensive or
c) the prospect of selling dollars now and buying them back when it falls even lower.

Provided that these reasons provide sufficient motivation, countries would then sell dollars when the dollar depreciates.

Initially I had another theorem in the above list: America uses its military hegemony to reinforce/prop up its economy, but to 'prove' it would lead me into conjecture and/or conspiracy theory territory, so I decided to leave it out. Click here for an intriguing look at this aspect (it also addresses the effect of oil on the scheme of things)

[*] If the American government is really keen on attracting investment in its treasury bonds, it can offer a higher rate of interest for them. But the flip side of this that the higher interest rate will suck capital from local banks, as a result of which regular borrowers (i.e. the public) would be faced with increased interest rates.