The U.S. Dollar and Its Role in Economics
The U.S. Dollar and Its Role in Economics
In a recent Investment Committee meeting, Dr. Scott Smart delivered a presentation on the U.S. Dollar, beginning with an analogy involving apples and bananas. For example, this week apples cost $5.00 and bananas cost $1.65. If next week apples cost $4.00 and bananas cost $2.00, we wouldn’t say that bananas "got stronger" and apples "weakened." These are just prices, like any other item we can trade, including currency. This analogy sets the stage for understanding the nature of exchange rates.
Building on this analogy, if the price of bananas goes up and you are a banana producer, that is good for you; but if you want bananas, the price increase is bad for you. Similarly, if the price of apples decreases, it is beneficial for consumers but detrimental to producers.
Exchange Rates:
The exchange rate is the price of one currency in terms of another.
- Over time, if a unit of one currency (such as the dollar, euro, yen, etc.) buys fewer units of another currency, we say it has depreciated. This change in value is an important concept for understanding currency movements.
- The dollar has depreciated against most currencies this year, but this is not unusual.
Decline in the value of the US Dollar:
- Pros:
- Helps U.S. exporters because their products are cheaper in other currencies.
- Helps U.S. investors holding assets denominated in foreign currencies.
- Cons:
- Hurts U.S. consumers because foreign products are more expensive.
- Hurts companies importing goods to the U.S.
- Hurts foreign investors holding dollar-denominated assets.
Predicting / Explaining Currency Movements:
- In the short run, currency movements are very hard to predict or even explain in hindsight.
- A currency’s price depends on supply and demand for the currency. If more entities want to buy the dollar and fewer want to sell, the price of the dollar should increase.
- In the long run, currency movements are driven by inflation.
- Higher inflation leads to currency depreciation.
- Lower inflation leads to currency appreciation.
Purchasing Power Parity:
- Big Mac Index:The Economist magazine looks across the globe twice a year to gauge currency valuation.
- What is the price of a Big Mac in the local currency? Then, using the exchange rate, determine what that would cost in dollars.
- The idea of purchasing power parity is for tradable items, over time there should be pressure to move these prices into equilibrium where the price is the same everywhere in one currency.
- If you could move a Big Mac (instantaneously) from Taiwan to the U.S, you could make arbitrage on that. You buy it in Taiwan for $2.66 and sell it in the United States for $6.01. Of course that doesn't work for Big Macs, but it does work for some goods.
- Where things look expensive, that currency should depreciate. Where it looks cheap, that currency should appreciate. The Big Mac index is a gauge for where prices of currencies should go (are they overvalued or undervalued).
Reserve Currency:
If the U.S. Dollar is the world's reserve currency, it means more central banks hold more dollars (i.e., more Treasury securities) than any other foreign currency instrument. Twenty years ago, more than 70% of worldwide central bank assets were held in dollars; now it is under 60%.
- Attributes of a Reserve Currency
- Liquidity: The U.S. Treasury market is approximately $30 trillion. So, if you are a medium-sized country, you have the ability to trade $100 billion quickly.
- Safety: You expect to get paid back because the country is relatively stable.
- Trust in Institutions: Institutions respect the rule of law and are independent of the central bank.
- Strong and Growing Economy: (Preferred, but not essential) U.S. Dollar does not lose its status during recessions.
- Benefits and Costs of Reserve Currency Status
- Benefits:
- The flight to safety phenomenon refers to the tendency for people to buy treasuries when the stock market declines.
- The U.S. government can borrow at lower rates than it otherwise could.
- Gives the U.S. govt financial leverage as a foreign policy tool (can impose sanctions if countries misbehave).
- Costs:
- If the dollar’s value is higher than it otherwise would be, that’s bad for exporters
- Flight to safety phenomenon means that the value of the dollar goes up, so exporters can be hit doubly hard during times of crisis (e.g., recessions).