## Solved Problem: How Does the Value of the U.S. Dollar Affect the U.S. and World Economies?

Supports: Macroeconomics, Chapter 18, Economics, Chapter 28, and Essentials of Economics, Chapter 19.

Between June 2021 and September 2022, the exchange rate between the U.S. dollar and an average of the currencies of the major trading partners of the United States increased by 14 percent. (This movement is shown in the figure above.) An article in the New York Times had the headline “The Dollar Is Strong. That Is Good for the U.S. but Bad for the World.”

1. Briefly explain what the headline means by a “strong” dollar.
2. Do you agree with the assertion in the headline that a stronger dollar is good for the United States but bad for the economies that the United States trades with? Briefly explain.
3. During this period the Federal Reserve was taking actions that raised U.S. interest rates. The article noted that “Those interest rate increases are pumping up the value of the dollar ….” Why would increases in U.S. interest rates relative to interest rates in other countries increase the value of the dollar?

Solving the Problem

Step 1:  Review the chapter material. This problem is about the effect of fluctuations in the exchange rate and the relationship between interest rates and exchange rates, so you may want to review Macroeconomics, Chapter 18, Section 8.2, “The Foreign Exchange Market and Exchange Rates,” or the corresponding sections in Economics, Chapter 28 or Essentials of Economics, Chapter 19.

Step 2: Answer part a. by explaining what a “strong” dollar means. A strong dollar is one that exchanges for more units of foreign currencies, such as British pounds or euros. (A “weak” dollar means the opposite: A dollar that exchanges for fewer units of foreign currencies.)

Step 3: Answer part b. by explaining whether you agree with the assertion that a stronger dollar is good for the United States but bad for the economies of other countries. A stronger U.S. dollar produces winners and losers both in the United States and in other countries. U.S. consumers win because a stronger dollar means that fewer dollars are needed to buy the same quantity of a foreign currency, which reduces the dollar price of imports from that country. For example, a stronger dollar reduces the number of dollars U.S. consumers pay to buy a bottle of French wine that has a 40 euro price.  A strong dollar is bad news for foreign consumers because they must pay more units of their currency to buy goods imported from the United States. For example, Japanese consumers will have to pay more yen to buy an imported Hershey’s candy bar with a \$1.25 price.

The situation is reversed for U.S. and foreign firms exporting goods. Because foreign consumers have to pay higher prices in their own currencies for goods imported from the United States, they are likely to buy less of them, buying more domestically produced goods or goods imported from other countries. U.S. firms will either to have accept lower sales, or cut the prices they charge for their exports. In either case, U.S. exporters’ revenue will decline. Foreign firms that export to the United States will be in the opposite situation: The dollar prices of their exports will decline, increasing their sales.

We can conclude that the article’s headline is somewhat misleading because not all groups in the United States are helped by a strong dollar and not all groups in other countries are hurt by a strong dollar.

Step 4: Answer part c. by explaining why higher interest rates in the United States relative to interest rates in other countries will increase the exchange value of the dollar. If interest rates in the United States rise relative to interest rates in other countries—as was true during the period from the spring of 2021 to the fall of 2022—U.S. financial assets, such as U.S. Treasury bills, will be more desirable, causing investors to increase their demand for the dollars they need to buy U.S. financial assets. The resulting shift to the right in the demand curve for dollars will cause the equilibrium exchange rate between the dollar and other currencies to increase.

Source:  Patricia Cohen, “The Dollar Is Strong. That Is Good for the U.S. but Bad for the World,” New York Times, September 26, 2022.

## Solved Problem: The Macroeconomic Effects of a Stronger Euro

Supports:  Economics: Chapter 28 – Macroeconomics in an Open Economy (Section 28.2); Macroeconomics: Chapter 12, Section 12.2; and Essentials: Chapter 19 – Comparative Advantage, International Trade, and Exchange Rates (Section 19.6)

Solved Problem: The Macroeconomic Effects of a Stronger Euro

In December 2020, an article in the Wall Street Journal discussed the effects of changes in the value of the euro in exchange for the U.S. dollar. The article noted that: “A stronger euro makes exports from the region less competitive overseas” and that a stronger euro would also “damp inflation” in countries using the euro as their currency.

a. What does the article mean by a “stronger euro”? Why would a stronger euro make European exports less competitive?

b. What does the article mean by “damp inflation”? Why would a stronger euro damp inflation in countries using the euro?

Source: Caitlin Ostroff, “Euro Rally Weighs on Inflation, Sapping Appetite for Stocks,” Wall Street Journal, December 9, 2020.

Solving the Problem

Step 1:   Review the chapter material. This problem is about the effect of changes in the exchange rate on a country’s (or region’s) imports and exports, so you may want to review Chapter 28, Section 28.2 “How Movements in Exchange Rates Affect Imports and Exports.”

Step 2:   Answer part a. by explaining what a “stronger euro” means and why a stronger euro would make European exports less competitive. A stronger euro is one that exchanges for more dollars or, which amounts to the same thing, requires fewer euros to exchange for a dollar. (You may want to review the Apply the Concept “Is a Strong Currency Good for a Country?”) A stronger euro results in U.S. consumers having to pay more dollars to buy goods and services imported from Europe. In other words, the prices of European exports to the United States will rise making the exports less competitive with U.S.-produced goods or with other countries exports to the United States. If the euro is also becoming stronger against currencies such as the British pound, Japanese yen, and Chinese yuan, then European exports will also be less competitive in those countries.

Step 3:   Answer part b. by explaining what “damp inflation” means and why a stronger euro would damp inflation in countries using the euro. To “damp inflation” is to reduce inflation. So the article is stating that a stronger euro will result in lower inflation in Europe. To understand why, remember that while a stronger euro will raise the dollar price of European exports to the United States, it will reduce the euro price of European imports from the United States (and from other countries if the euro is also becoming stronger against currencies such as the British pound, Japanese yen, and Chinese yuan). Inflation in a country is measured using the prices of goods and services that consumers purchase, whether those goods and services are produced domestically or are imported.