As part of your financial education in a global economy, you should understand global exchange rates. When importers bring foreign goods into the United States, they will put them up for sale at U.S. dollar prices. However, the manufacturer in the foreign country wants to be paid in the local currency. As you see below, supply and demand affect the value of one currency in terms of another, and this influences the price of an imported good in the United States.
Here is an example:
Price in Japan Exchange Rate Price in USA
1,000,000 Yen 100 Yen/US $ $10,000 US
1,000,000 Yen 90 Yen/US $ $11,111 US
1,000,000 Yen 110 Yen/US $ $9,090 US
Think of the exchange rate as the price of the foreign currency. Thus when the U.S. dollar can purchase 100 Yen, the 1,000,000 Yen price translates to 10,000 in U.S. dollars. If the U.S. dollar depreciates to 90 Yen/ U.S. dollar, the Toyota costs more in the U.S. If the U.S. dollar appreciates to 110 Yen/ U.S. dollar, the Toyota costs less in the U.S.
The bottom line is that a stronger U.S. dollar makes imports into the United States cheaper and incentivizes U.S. consumers to buy more imports. The contrary is also true: a weaker U.S. dollar makes foreign goods more expensive and discourages imports. Similarly, a weaker U.S. dollar makes U.S. exports cheaper and encourages foreign consumers to buy our goods. U.S. Presidents and Treasury Secretaries always say that they want a strong U.S. dollar, but secretly, they really do not. Overall, a weaker dollar is good for the U.S. economy.
The basic law of supply and demand causes fluctuations in the valuations of currencies relative to one another. Even with these fluctuations, there are a number of reasons someone who holds a foreign currency would want to trade them for U.S. dollars:
- To buy U.S. Exports. U.S. companies who are exporting goods and services to a foreign company want to be paid in U.S. dollars, so foreign importers must exchange their currency for U.S. dollars.
- To invest in U.S. Investments, such as the U.S. Stock Market, the U.S. Bond Market, U.S. Real Estate, or to buy a U.S. company. Investors from every country in the world invest in the U.S. Stock and Bond Markets. They are considered one of the most reliable investment markets in the world. Since the stocks and bonds in these markets must be paid for in U.S. dollars, anyone buying U.S. stocks or bonds (or U.S. Real Estate or U.S. companies) must exchange their currency for U.S. dollars.
- Speculation on the volatility in the value of currencies (or “hot money”). Currency values fluctuate every day relative to each other. Usually, these daily fluctuations are small. However, over a year or longer, there can be significant changes in the relative value of currencies, caused by supply and demand for particular currencies. For example, if an investor expects the U.S. dollar to appreciate 10% over time against the Japanese Yen, they can buy and hold dollars until they rise against the Yen. Then, after converting the dollars back to Yen, the investor will earn 10% (minus any transaction costs).
For a real-world example, the U.S. dollar appreciated 4.3% in 2018 and continued to appreciate in 2019 (measured against a basket of foreign currencies) due to an influx of foreign money into U.S. investments. Foreign stock and bond markets were not doing as well as their U.S. counterparts at the time, so foreign investors had to trade their currency for U.S. dollars in order to invest in American markets. The demand for U.S. dollars caused it to rise and as a consequence, foreign imports became cheaper, and the U.S. brought in more imports.
It’s all pretty complicated, but that’s the real world. Since 2019, the U.S. dollar has stopped its appreciation (after a brief jump during the Pandemic Recession), as seen in the graph below:
Figure 4.4. Board of Governors of the Federal Reserve System (US), Trade Weighted U.S. dollar Index: Broad, Goods and Services [DTWEXBGS], retrieved from FRED, Federal Reserve Bank of St. Louis; September 29, 2021.
The U.S. dollar is also the preferred currency for several Central Banks, and it is the preferred international currency. As a result, the U.S. dollar is involved in over 90% of over $4 trillion dollars’ worth of foreign exchange trades every day.