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2008-08-31 BACK
WEAKER DOLLAR: CURSE OR BLESSING?
WEAKER DOLLAR: CURSE OR BLESSING? This article originally appeared in the Texarkana Gazette on August 31, 2008 By Mohammed Ashraful Haque,Ph.D., Professor of Finance, Texas A&M-Texarkana College of Business One of the reasons we are paying high prices for oil is the weak U.S. dollar. Because oil is the only commodity, regardless of from where you buy it, the payment must be made in U.S. dollars. The weak dollar costs you more when you go overseas for a vacation or when you buy foreign goods. That's the bad news. However, U.S. exports benefit from the weaker dollar because of the relative lower prices on U.S. goods and services paid for with stronger foreign currencies. In this column I discuss several aspects of the current weak dollar and implications for U.S. businesses and consumers. First, let us discuss why the value of the dollar is low compared to other major currencies. The two most well established theories of exchange rate determination are Purchasing Power Parity and Interest Rate Parity. Purchasing Power Parity means that the exchange rate is determined by the relative prices in two countries. In simple terms, this means that if five apples cost $1 in New York and ten apples cost £1 in London, then the exchange rate would be £1 = $2. The other theory of exchange rate is Interest Rate Parity. This states that one cannot make riskless profits by speculating in foreign exchange markets due to different interest rates in different countries. Let us say, for example, that the interest rate is 8 percent in the U.S. and 6 percent in the U.K. Investors in the U.K. will want to transfer funds to the U.S. to invest at the higher prevailing interest rate. Suppose they have a three month investment horizon. At the end of three months the pound will appreciate against the dollar. Because of the depreciation of the dollar, the U.K. investor will receive fewer pounds which will wipe out any gain made because of the higher interest in the U.S.; therefore, the British investor will not be any better off by investing in the U.S. to take advantage of the higher interest rates. As such, increasing U.S. interest rates will initially increase the value of the dollar. Because there would be an influx of foreign currencies, the dollar will appreciate because of the higher demand for the dollar. But, at the end of the investment horizon, when foreign investors convert their dollar investment, the value of the dollar will depreciate because all foreign investors will try to sell the dollar. This causes an excess of supply. It is true that the weaker dollar costs you more when you buy foreign goods or travel overseas. You also pay higher prices for oil. But because foreign goods become more expensive, U.S. consumers buy less foreign goods which will lower the import burden. Moreover, as the dollar becomes weaker, American goods become cheaper overseas. Let us assume a U.S. manufactured car costs $30,000 and the exchange rate is $1.50 = £1.00. For someone in London, the U.S. automobile costs £20,000. Now assume the dollar depreciates in value against the pound so that £1 = $2. The price of the U.S. automobile will drop to £15,000 in London. Therefore devaluation of the dollar will increase U.S. exports which will create U.S. jobs by increasing U.S. exports. Devaluation of the dollar is both a curse and a blessing. Gradually when exports increase, the value of the dollar will increase, because payments for U.S. goods must be paid in dollars and increased demand for dollars will increase its value. As usual, there is a quick fix to this. The Federal Reserve can increase interest rates which will attract foreign investors causing a high demand for the dollar and increasing the value of the dollar. However, this is not advisable in the long run because higher interest will lower investment and will slow down the economy. It is always best to let the market stabilize itself. Dr. Mohammed Ashraful Haque Email mohammed.haque@tamut.edu
TOP
WEAKER DOLLAR: CURSE OR BLESSING?
WEAKER DOLLAR: CURSE OR BLESSING? This article originally appeared in the Texarkana Gazette on August 31, 2008 By Mohammed Ashraful Haque,Ph.D., Professor of Finance, Texas A&M-Texarkana College of Business One of the reasons we are paying high prices for oil is the weak U.S. dollar. Because oil is the only commodity, regardless of from where you buy it, the payment must be made in U.S. dollars. The weak dollar costs you more when you go overseas for a vacation or when you buy foreign goods. That's the bad news. However, U.S. exports benefit from the weaker dollar because of the relative lower prices on U.S. goods and services paid for with stronger foreign currencies. In this column I discuss several aspects of the current weak dollar and implications for U.S. businesses and consumers. First, let us discuss why the value of the dollar is low compared to other major currencies. The two most well established theories of exchange rate determination are Purchasing Power Parity and Interest Rate Parity. Purchasing Power Parity means that the exchange rate is determined by the relative prices in two countries. In simple terms, this means that if five apples cost $1 in New York and ten apples cost £1 in London, then the exchange rate would be £1 = $2. The other theory of exchange rate is Interest Rate Parity. This states that one cannot make riskless profits by speculating in foreign exchange markets due to different interest rates in different countries. Let us say, for example, that the interest rate is 8 percent in the U.S. and 6 percent in the U.K. Investors in the U.K. will want to transfer funds to the U.S. to invest at the higher prevailing interest rate. Suppose they have a three month investment horizon. At the end of three months the pound will appreciate against the dollar. Because of the depreciation of the dollar, the U.K. investor will receive fewer pounds which will wipe out any gain made because of the higher interest in the U.S.; therefore, the British investor will not be any better off by investing in the U.S. to take advantage of the higher interest rates. As such, increasing U.S. interest rates will initially increase the value of the dollar. Because there would be an influx of foreign currencies, the dollar will appreciate because of the higher demand for the dollar. But, at the end of the investment horizon, when foreign investors convert their dollar investment, the value of the dollar will depreciate because all foreign investors will try to sell the dollar. This causes an excess of supply. It is true that the weaker dollar costs you more when you buy foreign goods or travel overseas. You also pay higher prices for oil. But because foreign goods become more expensive, U.S. consumers buy less foreign goods which will lower the import burden. Moreover, as the dollar becomes weaker, American goods become cheaper overseas. Let us assume a U.S. manufactured car costs $30,000 and the exchange rate is $1.50 = £1.00. For someone in London, the U.S. automobile costs £20,000. Now assume the dollar depreciates in value against the pound so that £1 = $2. The price of the U.S. automobile will drop to £15,000 in London. Therefore devaluation of the dollar will increase U.S. exports which will create U.S. jobs by increasing U.S. exports. Devaluation of the dollar is both a curse and a blessing. Gradually when exports increase, the value of the dollar will increase, because payments for U.S. goods must be paid in dollars and increased demand for dollars will increase its value. As usual, there is a quick fix to this. The Federal Reserve can increase interest rates which will attract foreign investors causing a high demand for the dollar and increasing the value of the dollar. However, this is not advisable in the long run because higher interest will lower investment and will slow down the economy. It is always best to let the market stabilize itself. Dr. Mohammed Ashraful Haque Email mohammed.haque@tamut.edu
TOP