Exchange Rates and Their Impact on the U.S. Economy
The role that exchange rate plays in the economy on the global scale is hard to overestimate. When people or legal entities intend to purchase goods or services from people or legal entities in another country, they require, first of all, to buy the said country’s currency for one simple reason: foreign companies use their own currencies. As a result, they are entering into foreign exchange market and use exchange rates to convert their currency into another country’s currency in order to pay for the desired products. Thus, the most important role of the exchange rates is that they facilitate international trade allowing the transfer of funds between countries. Exchange rates also help to make a quick price comparison of similar products in different countries. Companies that engage in international trade use price comparison to determine which goods to trade, in which country to buy and where to sell certain products. Therefore, changes in the value of a currency of a certain country can significantly impact not only international trade but also the whole economy of a country. Thus, the aim of this paper is to examine the role that exchange rates play in country’s economy, what factors determine the currency value and how changes in the value of the currency can affect different sectors of the economy, taking U.S. economy as an example.
The exchange rate between the two currencies can be best explained as the rate using which one currency can be traded for another country’s currency. The Federal Reserve Board on its website presents a summary of average monthly exchange rates of the U.S. dollar against the common currencies of main trading partners of the USA (Foreign Exchange Rates — G.5). Normally, the exchange rates fluctuate on a daily basis, whereas the rates provided on the site reflect the average monthly fluctuations regarding the exchange while providing comparable figures for other months. For example, the average exchange rate between the U.S. dollar and the Swiss franc as at January 2015 was registered as US$1 = 0.94, which means that each dollar was worth 0.94 francs. On the similar note, the exchange rate between the U.S. dollar and the Japanese currency, yen, was registered at US$ = 118 yen, meaning that for each U.S. dollar was equal to 118 yen.
In case when the exchange rate of the US dollar goes up against some other foreign currency, it means that more units of the respective currency can be purchased against the U.S. dollar. In such cases, the U.S. currency is interpreted as having appreciated or strengthened its position. For example, the exchange rate of the U.S. dollar versus Canadian dollar was subject to change from US$ 1= 1.09 (as at January 2014) to US$1 = 1.21(as at January 2015). In this case, the US dollar has strengthened while the Canadian dollar respectively depreciated or weakened its position. The U.S. dollar also gained against the Japanese yen when the exchange rate increased from US$ 1 = 103 (as at January 2014) respectively to US$1 = 118 (as at January 2015). When analyzing the table on the Federal Reserve Board’s site, one can observe the general trend whereby, within the last year, the U.S. dollar has been strengthening its position. What factors had influenced the strengthening of the U.S. dollar and did they influence the economy of the USA in a positive or rather a negative manner?
There is a broad array of versatile factors that can directly influence the level of the exchange rate of a certain currency. However, the main factors are the market forces that drive the ratio between supply and demand. In the event when the demand for a certain currency increases, the price of that currency consequently is pushed higher whereby the currency is strengthening. On a similar note, there is a number of factors that can lead to the increased demand for a certain currency. For example, the activities of foreign investors can push the demand for the U.S. dollar higher if they invest in the United States as a more attractive option than in their own countries. On a similar note, the increased demand for the U.S. exports would also drive the demand for U.S. dollar up as foreign firms would require more U.S. dollars to pay for those imported from the USA goods or services.
There is also a number of other factors that determine the value of the currency, such as the government, interest rates, inflation, consumers’ preferences of particular foreign goods or services, and consumers’ future expectations. While the consumer preferences and expectations are difficult to assess, other factors are important to examine. Governments can influence the value of the home currency by direct or indirect measures. Thus, the government can employ the direct measures and set up the “fixed” exchange rates as it had been done by Chinese government in 1994. The exchange rate between the U.S. dollar and Chinese yuan was fixed at the rate of 8.28 yuan = US$1 for a couple of years. In most countries, however, governments regulate the exchange rates indirectly by means of changing interest rates, which ultimately affects the amount of money in circulation. In contrast, governments can also exercise indirect measures in order to balance out the level of the exchange rate, such as selling or buying other foreign currencies on the foreign exchange market or optimizing investment opportunities for foreign investors (Evans).
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Fluctuations in the exchange rate of the U.S. dollar can have both positive and negative influence on the U.S economy, depending on the industry segment. When the U.S. dollar strengthens its position, the cost of the imported goods gets cheaper. The U.S. consumers will consequently benefit from this situation because they will be able to buy imported goods and services at a respectively cheaper price. On the other hand, the stronger dollar makes the U.S export more expensive and therefore less competitive overseas, which, in its turn, decreases the demand on the U.S. products. The cheap imports make locally produced goods less competitive including on the domestic markets. This situation can negatively impact the overall profitability of businesses with high international sales (Doidge 23).
When the U.S. dollar exchange rate decreases and thus the dollar gets weaker, the effect on the economy will be exactly the opposite. The point is, a depreciated U.S. currency will make the U.S. cost of export goods and services cheaper for foreign buyers, and consequently the demand for the U.S. goods and services thus will increases overseas. The increased demand for U.S. exports always translates into increased profits for domestic companies that sell the products to the foreign countries. This situation will be obviously beneficial for the local producers since their goods gain a competitive edge on the domestic markets as compared to rather expensive imported goods. Thus, a weak U.S. dollar has a positive effect in terms of profitability of those sectors in the U.S. economy that engage in exports activities to overseas markets. However, in this situation, the U.S. consumers and U.S. firms that import goods from the foreign countries, will need to pay higher prices for the imported goods and services. It is noteworthy that some industries in the U.S. that heavily depend on energy consumption would not benefit from a depreciated dollar because this would mean a higher cost for imported energy and other inputs that go into the production process. Thus, a sharp decline in the value of the U.S. dollar would mean a sharp increase in energy bills which can minimize the possible gains for such industries. A dramatic decline of the U.S. dollar would also mean a high inflation rate, which always has an adverse effect on functioning of any economy (Heim 2)
When the U.S. dollar is strong, this situation is more beneficial for the U.S. consumers and the U.S. importers, as they can buy imported goods and services cheaper. Such U.S. commercial enterprises like grocery stores, retail electronics firms, gas stations, and other retail and wholesale firms that are trading imported commodities, enjoy higher profits. However, these times would not be favourable for American exporters since their products become more expensive and less competitive overseas as well as in the domestic markets. The strong dollar has a negative effect on a number of U.S. industries, such as computer companies, auto manufacturers and agricultural businesses that are the main U.S. exporters. The strengthening dollar results in lower profits for these companies and sometimes can even drive some firms out of business. The U.S. local farmers are among those who are the most vulnerable to the strengthening of the U.S. dollar. At bad times they often seek compensation from the government for their losses as they have to lower their prices to maintain the demand for their products. Thus, the changes in the value of the U.S. dollar can have a positive effect on some industries and the negative effect on the other industries. While the U.S. importers favor a strong dollar, the U.S. exporters enjoy the situation when the U.S. dollar is weak.