By- Shagun Khetan Edited by- Siya Kohli
“I’m not concerned about the strength of the dollar, I’m concerned about the rest of the world,” said Biden on October 15, 2022, during a campaign stop in Portland, Oregon.“Our economy is strong as hell.”
Biden’s comments stand in contrast with top leaders from other countries– (including but not limited to his predecessor, Donald Trump, Japan’s Finance Minister, Shunichi Suzuki, India’s Finance Minister, Nirmala Sitaraman) who have increasingly voiced concerns about how the rising greenback is fueling inflation in their own economies. The dollar had climbed roughly 15% in 2022 as the Federal Reserve embarked on an aggressive campaign to raise interest rates to tamp US price increases.
A question then arises, “Does a strong currency imply a strong economy?” Intuitively, one might yield to answering in the affirmative. But such discussions should start with some basic economics. Let’s go back.
Let’s go back to the model that shows how the market for loanable funds and the market for foreign currency exchange jointly determine the important macroeconomic variables of an open economy.
As the figure below shows, the first graph shows the market for loanable funds where national saving is the source of supply and domestic investment and net capital outflow are the sources of demand and the equilibrium real interest rate r1 brings both of the variables into balance. Further, graph (b) shows net capital outflow which is determined by the real interest rate. A higher real interest rate at home makes domestic assets more attractive, and this in turn reduces the net capital outflow, making the graph slope downwards. Finally, graph (c) shows the market for foreign currency exchange. Since foreign assets must be purchased with foreign currency, the net capital outflow determines the supply of dollars to be exchanged into foreign currencies. The real exchange rate does not affect the net capital outflow, so the supply curve is vertical. The net exports represent the source of demand and slope downwards because the depreciation of the real exchange rate will increase the net exports. The equilibrium real exchange rate E1 brings both of the variables into balance.
With that in perspective, we can now use this model to analyse how changes in policy and other events alter the economy’s equilibrium and change the currency’s value. Let’s try answering the question that came up before, “Does a strong currency imply a strong economy?”
The exchange rate is a price much like any other price, and is determined by market forces. In terms of dollars, the exchange rate is the price of the dollar in terms of other currencies. And a high price for the dollar, which is what we mean by a strong dollar, is not always desirable.
Different situations can cause a currency to strengthen, that doesn’t necessarily qualify as a good indicator of the economy. Here are two totally different scenarios that caused the dollar to strengthen:
The 1990s. Globalisation was in full swing, and in ways that redounded distinctly to the good of the United States. American entrepreneurs created many products that foreigners wanted to buy, and started many companies that they wanted to invest in. This increased the demand for dollars in the market for foreign currency exchange and so caused the dollar’s price to rise. Such innovation also made Americans want to buy more goods and assets in the United States–and eventually, fewer abroad. This resulted in a reduction in the supply of dollars in the foreign currency exchange market, further strengthening the dollar.
US Dollar Index
This looks pretty good, right? Even Joseph Stiglitz, the then chief economist of the World Bank, commented, “There is no question that the nineties were good years. Jobs were created, technology prospered, inflation fell, poverty was reduced.”
Now let’s go back a decade further. The 1980s. Over the course of 1980, interest rates spiked, fell briefly, and then spiked again. Lending activity fell, unemployment rose, and the economy entered a brief recession between January and July. Inflation fell but was still high even as the economy recovered in the second half of 1980. During this period, the United States ran into large budget deficits due to President Ronald Reagan’s tax cuts and military buildup causing the domestic interest rates to rise. (deficit = negative public saving = supply reduction in the market for loanable funds = ↑ interest rates) Higher American interest rates make both foreigners and Americans want to buy more American bonds and fewer foreign bonds, increasing the demand for dollars and decreasing the supply of dollars in the market for foreign currency exchange. Voilà, the price of the dollar rises dramatically.
US Dollar Index
Both developments–brilliant American innovation and troublesome American budget deficits–caused the dollar to strengthen. Yet, one is clearly positive for the American economy, the other a negative.
The point is that there is no universal good or bad direction for a currency to move. The desirability of any shift in the exchange rate depends on why that currency is moving. It also depends on other factors as well, such as the state of the economy, for instance. At full employment, a strong currency is good for standards of living because it means that the home currency can buy a lot of things in other countries. In a depressed economy, however, a strong currency won’t be desirable because a cheaper currency is required to stimulate exports to raise production and employment.