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Written by Polina Vlasenko
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Thursday, 28 August 2008 19:00 |
The sharp fall of the dollar relative to other currencies, most notably the euro, over the last several years has many in the U.S. worried. At its peak in 2000, one dollar bought you more than one euro, but now it takes more than $1.50 to buy one euro. Secretary of the Treasury Henry Paulson and the Fed Chairman Ben Bernanke, among others, recently have voiced concerns about the strength of the dollar. Its weakness has been blamed for high energy prices and high commodity prices in general.
Surprisingly, the weak dollar brings some benefits. Economic theory and common sense say that when the dollar gets cheaper, U.S. products also become cheaper relative to those made in other countries and U.S. firms become more competitive in international markets. Exports should increase. In addition, U.S. imports should fall as the weaker dollar leads Americans to buy fewer foreign goods and services. Because of this net exports (exports minus imports) should increase. Since net exports are one of the components of the gross domestic product, an increase in net exports should contribute to the GDP growth. This is exactly what we see happening in the U.S. right now. In April, the dollar has reached the lowest point against the euro since the euro’s introduction in 1999. In March, the index that measures the foreign exchange value of the dollar relative to currencies of major U.S. trading partners reached the lowest point since 1995. Simultaneously, in the second quarter of 2008, U.S. net exports increased substantially. This increase in net exports was the strongest contributor to the growth of real GDP in the second quarter of 2008, as reported by AIER in a recent commentary. This is not just a one-time occurrence. The growth of net exports has been accelerating since 2006 while the dollar has been falling against the currencies of U.S. trading partners. The chart below shows the index of the foreign exchange value of the dollar. The index, which is reported by the Federal Reserve, is a weighted average of the values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. An increase in this index indicates appreciation of the dollar. Economic theory suggests that we should see an increase in the growth of net exports when the dollar is weakening, which is exactly what started to happen in 2006.
The growth rate of net exports on the chart is more volatile than changes in the exchange rate alone would suggest because additional factors (such as trade policies or economic growth in the U.S. and its trading partners) affect net exports. As the dollar has weakened, net export growth has accelerated Moreover, there is a self-correcting mechanism built into the market. The value of a currency, as the value of any other product, essentially depends on the supply and demand for it. Increased demand for U.S.-made products leads to higher demand for dollars, which are required to buy those products. In addition, faster GDP growth created by higher net exports leads to higher income and higher spending within the U.S., which also leads to higher demand for dollars. Thus, eventually the demand for dollars would increase, leading to appreciation of the dollar unless there are sharp changes in supply. The dollar cannot keep falling forever. The impact of currency supply on exchange rated is not trivial. Supply is controlled by central banks. Besides market forces, what will happen in to the value of the dollar also depends on actions by the Federal Reserve.
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These differences, however, do not negate the basic laws of supply and demand, which connect the changes in demand to the price of the product. You correctly point out that when the demand for toothbrushes increases, producers will supply more of them. The reason for this is, of course, that as demand for toothbrushes increases, their price goes up. It is this increase in price that induces profit-maximizing producers to produce more toothbrushes.
Similarly, when demand for dollars rises, the value of the dollar increases. So, in this respect currency is exactly like toothbrushes – when demand for it rises, its value goes up. Where the currency differs from toothbrushes is in the response of the supplier to the increase in value.
Would an increase in value of dollars lead to an increase in their supply? This depends exclusively on the action of the Fed. If the Fed did not have the option of increasing the money supply (as was the case under the gold standard, for example) then no additional dollars would be “produced”. In today’s world of fiat currencies, however, the Fed can adjust money supply at any time. An increased demand for dollars, in the absence of other changes, would eventually lead to an increase in interest rates in U.S. (the complete explanation of this connection is a bit longer than the space here would allow for). If the Fed has a policy of maintaining fairly constant interest rates, it would choose to increase the money supply to prevent interest rates from rising.
This leads into the answer to your second point. The Fed’s actions are the major determinant of the value of the dollar. In fact, AIER has been pointing out for a long time that central bank’s policy of inflating (printing of additional dollars) has resulted in the dramatic decrease in the purchasing power of the dollar. For the chart showing the evolution of the purchasing power of the dollar, you can see The AIER Chart Book, The AIER Cost-Of-Living Guide, or this recent commentary -- http://www.aier.org/research/commentaries/147-new-5-bill-protection-against-phony-money.
Central banks of other countries also tend to increase supply of their currencies over time, so the value of dollar relative to other currencies largely depend on which central banks increases the supply of their currency faster.