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Exchange rates

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  • Textbook/
  • Chapter 4: The Global Economy/
  • Economics real world examples and extension material /
  • Exchange rates

The causes and consequences of a rise in the value of the US Dollar

One of the consequences of the military conflict in Ukraine has been the movement of money into ‘safe-haven’ investments such as gold, silver and platinum. The price of gold, for example, has risen to an 18-month high at $1,943 an ounce. Investors often look to put their money into precious metals during times of international conflict because people are attracted by the intrinsic value of commodities such as gold and silver.  

In a similar way, the US Dollar is often seen as a ‘safe-haven’ currency by investors and international money flows have moved into the US Dollar as the Ukraine conflict has developed. The US Dollar is the most widely traded currency in the world and the financial assets of the world’s biggest economy are attractive as a safe investment.

The US Dollar is currently trading at a one year high against the US Dollar Index which is a measure of the value of the US Dollar relative to the value of a basket of currencies of America's major trading partners. The US Dollar has risen significantly against most major currencies in the last year. Against the Euro, for example, the US Dollar was trading at €0.82c to $1 and it is currently trading €0.90c to $1 an appreciation of nearly 10 per cent.

The increase in the value of the US Dollar in most recent days is partly due to its ‘safe-haven’ status, but this does not account for the strength of the Dollar over the last 12 months. One reason for the appreciation of the Us Dollar over the last year is the interest rate outlook of the US central bank.  The Federal Reserve is looking to start to increase its base interest rate as part of its monetary policy to tackle the US inflation rate which has reached 7.5 per cent which is the highest level for a generation. The potential for rising interest rates in the US attracts investment funds looking for higher returns along with speculative ‘hot money’ flows into the US which increases the demand for the US Dollar leading to an appreciation in the US Dollar exchange rate.

The US economy has also rebounded strongly from the recession caused by the Covid19 pandemic and the growth rate of 7 per cent in the final quarter of 2021 increases sentiment towards the US economy from investors and this also increases the demand for the US Dollar.

The appreciation of the value of the US Dollar will be useful in the fight against inflation in the US as a stronger currency will reduce import prices and costs to businesses who import inputs from overseas. It will, however, make export markets for US exporters more challenging as the price of US goods sold aboard become more expensive.

Questions

1. Explain why an increase in the US interest rates might lead to a rise in the value of the US dollar. 

If US interest rates increase this means the return on US financial assets (bonds and bank accounts) will rise and this will attract portfolio investment into the US economy leading to an increase in demand for the US Dollar. The increase in portfolio investment into the US will also attract speculative investment flows (hot money) into the US and this will further increase the demand for the US Dollar. The rise in demand for the US Dollar will lead to an appreciation in its value. 

2. Explain why investors might be attracted to the US Dollar in times of international conflict and instability. 

Investors might buy the US Dollar in times of global instability because it is considered a 'safe-haven' asset. This means investors consider the US Dollar as a safe place to hold their wealth because it minimises their risk of losing money relative to other currencies and assets.

3. Evaluate the benefits to the US economy of an appreciation in the value of the US Dollar. 

An appreciation of the US dollar has the following benefits:

  • Import prices fall which reduce the price of imported finished goods for consumers. 
  • The cost of imported raw materials and components decreases which lead to higher businesses profits and lower prices for consumers.
  • American tourists find foreign travel less expensive.
  • US firms find investing abroad less expensive. 

Evaluation might include discussion of the disadvantages to the US of an appreciation in the US Dollar:

  • US exporters will become less competitive on overseas markets as the price of their goods increases.
  • It may be more difficult to attract foreign investment into the US economy because of the increased cost.
  • Fewer tourists might come to the US because of the higher price of travel.