There has been some recent discussion of no longer allowing the markets to determine the value of the dollar by taking actions that affect the dollar to increase exports. But concerns that the dollar is too strong require some deeper thinking regarding the determinants of currency value.
There are several main considerations in determining currency value, and some of these variables are more important for the dollar than others. Like most developed countries, the U.S. allows the currency to float and does not explicitly take actions to affect the value of the dollar. The importance of each one of these mechanisms for the value of the dollar changes over time.
One mechanism affecting currency value is the trade balance. The trade balance is included in the balance of payments, similar to a firm’s cash flow statements. It measures how much a country buys relative to how much it sells in foreign countries. When a country buys more than it sells, it has a trade deficit, which will negatively affect the value of its currency. The U.S. has a trade deficit, which in general is not ideal. But the U.S. is unique in that it is an important investment destination for foreign investors. The fact that foreign investors like to invest in dollar-denominated assets is a positive force on the dollar. It is important to note that the dollar is the most-held reserve asset. Therefore, it is in the self-interest of countries holding the dollar as a reserve asset that the dollar remains strong.
Next, the dollar’s value is affected by relative interest and inflation rates. Countries with high rates will have lower currency values over time. High inflation weakens a currency, requiring consumers to use more dollars to purchase goods over time. With interest rates, the effect is similar in that countries need to offer higher rates to attract foreign investment and similar to inflation in asset prices. At the moment, both rates are relatively low for the U.S., and foreign investment remains strong reflecting strength in the dollar.
Finally, the dollar is influenced by the overall strength of the economy. Currencies can be viewed as the relative stock value of the country. The dollar will be stronger if there is relative optimism in the U.S. economy and vice versa. The market believes in the growth or development of the economy and in turn the currency value is affected by government decisions, such as the imposition of tariffs. If markets believe that tariffs will have a positive effect on trade, then the currency will appreciate. But if markets believe tariffs are counterproductive, then the currency will depreciate.
A weaker dollar means Americans will be poorer as they will lose significant spending power. This is particularly important for Americans since we buy many imported goods, such as cars, electronics and textiles. The higher cost of foreign goods will have an inflationary effect, since prices of goods and services will increase due to the weaker dollar and would result in a negative wealth shock.
A weaker dollar may help U.S. exporters. The argument is that the increase in exports will create jobs and lead to economic growth. Though it may help U.S. exporters since the price of American goods will be cheaper in foreign currencies, the increased demand may also lead to an increase in prices denominated in dollars, which would increase the price to Americans. Additionally, American consumers, in the face of increased prices of foreign goods, may choose to buy fewer domestically produced goods so they can continue to consume foreign goods that they may prefer.
A strong dollar makes Americans wealthier because they can consume more imported goods. The catch is that U.S. goods are more expensive for foreigners, making them less competitive relative to foreign-produced goods. This lack of exports will create a greater trade deficit, possibly weakening the economy over time, although it is not an immediate concern since the other two factors add to the dollar’s strength. If the dollar gets too strong, weak export sales could slow the economy.
The dollar is not currently too strong. With the economy expanding, though at a slower pace than desired, consumer confidence is high and there are few signs of an impending economic calamity. The strong dollar also allows for relatively low interest rates, spurring economic growth. Overall, continuing to allow the markets to determine the value of the dollar is the appropriate approach and the best solution for continued economic growth and stability.
Rohan Williamson is professor of finance and the Bolton Sullivan and Thomas A. Dean Chair of International Business in the McDonough School of Business at Georgetown University.