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YOU DECIDE: What's behind the lower dollar?

November 30, 2007

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

Dr. Mike Walden
Media representatives: For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

The headlines about the U.S. dollar appear ominous.

Recently, the dollar's value against a collection of foreign currencies fell to its lowest level in decades. The Canadian dollar - the currency of our largest trading partner - is now worth more than the U.S. dollar. These facts certainly don't sound good for our economy. Are they?

To see, let's go to some fundamentals. Any currency - like the U.S. dollar - will trade for another currency - such as the euro - at some rate. Let's say the rate is $1.30 equals one euro. We would call this rate the "exchange rate" of dollars for euros. There are also exchange rates of the dollar for other currencies.

At one time most of these exchange rates were fixed, meaning the number of dollars required to equal one unit of a foreign currency never changed. However, today many of the exchange rates between currencies are flexible, meaning they can change. For example, the exchange rate between the dollar and the euro is flexible.

When the dollar "strengthens" against a foreign currency, this means it takes fewer dollars to equal one unit of that currency than in the past. So, a stronger dollar against the euro might mean it now takes $1.25 to equal one euro, rather than $1.30.

Conversely, when the dollar "weakens" against a foreign currency, more dollars are now needed to equal one unit of the foreign currency. An example would be an increase from $1.30 to $1.40 required to obtain one euro.

What would cause the dollar's exchange rate to change? Since the exchange rate is really a price, the answer is based on the standard economic concepts of supply and demand; in this case, the supply of and demand for dollars.

Consider this analogy: If there are more apples available for sale (supply) than people want to buy (demand), then the price of apples drops. On the other hand, if there are too few apples available to meet the number that people want to purchase, then the price rises.

Just replace "apples" in the above paragraph with "dollars" and you have the fundamental reasons why the dollar weakens or strengthens.

The dollar weakens (it takes more dollars to equal one unit of a foreign currency) if the supply of dollars in the world is greater than the number of dollars that foreigners want to have. On the flip side, the dollar strengthens (it takes fewer dollars to equal one unit of a foreign currency) if the world supply of dollars is less than the number of dollars foreigners would like to hold.

Since the dollar has been "weakening" against foreign currencies for most of the past six years, it must mean the world supply of dollars has been increasing faster than the world's desire to use those dollars. And the reason is a linkage straight out of economics 101: the U.S trade deficit. As the U.S. trade deficit - which is the excess of U.S. imports over U.S. exports - has grown to record levels, more and more dollars have been pumped into the world's supply. Just as the price of apples falls when there's an enormous harvest resulting in a big jump in the apple supply, so too the dollar has weakened as American's purchase of foreign products has flooded the world with dollars.

Yet one of the amazing features of economics is the ability of price changes to move markets back to balance. When too many apples push their price down, the lower price will both discourage production and encourage purchases, and both these trends will push apple supply and apple demand toward equality.

In the same way, a weaker dollar will stimulate U.S. exports while moderating U.S. imports, thereby resulting in a smaller trade deficit. Indeed, the trade deficit has shrunk by 15 percent over the past two years. As this continues, the brake will ultimately be put on the dollar's slide.

Swings in the dollar's exchange rate are not unusual. In the last 30 years, there have been two major cycles, with high points for the dollar's value set in 1985 and 2002 and low points in 1978 and 1995. We're now in another low phase.

History (and economics) suggests the dollar's value will eventually swing back up, but you decide if history is a good guide!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html

Posted by Dave at November 30, 2007 08:00 AM