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Declining Dollar: Plunge is already sending ripples through the economy

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The dollar sank to a record low against the euro Thursday and traded at parity against the Canadian currency for the first time since 1976.

The greenback's latest plunge to more than $1.40 to the euro was triggered by the Federal Reserve's half-point interest rate cut earlier this week. By cutting its target for short-term rates, the Fed aims to offset damage to the economy from an ongoing credit crunch.

Breeching $1.40 is thought to be significant because that level has long been seen as a key benchmark in terms of solidifying the euro's position on currency markets and giving it momentum toward becoming a reserve currency of choice — a position currently held by the dollar.

Lower interest rates make the dollar — and dollar-denominated stocks and bonds — less attractive to global investors. The sinking dollar already is sending ripples through the economy, and worse conditions could lie ahead. "There's still plenty of downside there. We don't really know how far it's going to fall," said economist Nigel Gault of Global Insight.

As the dollar sinks, consumers find imported products — Australian wines, Japanese cars or Chinese toys — are more expensive. Even as it cut interest rates earlier this week, the Fed vowed to "monitor inflation developments carefully."

Inflation fears Thursday helped send yields higher on 10-year Treasury securities for the fourth day in a row. The United States depends on foreign investors to purchase massive quantities of its government securities to finance a chronic current account deficit, the broadest measure of the overall trade balance.

Consumers, too, will feel the effects if investors shy away from Treasuries because rates on 30-year mortgages are influenced by the yield on 10-year notes. If investors demand higher yields to buy those securities, mortgage rates will rise just as the battered housing industry craves easier credit.

"Anybody who wants to borrow at a fixed rate or refinance out of an adjustable rate into a long-term fixed rate, it's bad news," says Gault.

Still, the weaker dollar is a boon for U.S. exporters whose goods are now less expensive for foreign customers. Net exports in the second quarter boosted economic growth by 1.4 percentage points as companies such as Caterpillar and Boeing racked up strong overseas sales.

So far, the dollar's decline has been gradual. If investors were to suddenly dump their holdings of the U.S. currency, the Fed's job of managing an already-troubled economy would instantly grow more complicated.

A plunging dollar would argue for interest rates to be raised, to encourage investors to hold dollars. But higher rates would be a drag on an economy that is weakly advancing. "That's the kind of nightmare the Fed wants to avoid," says Morris Goldstein of the Peterson Institute for International Economics.

The Associated Press contributed to this report.