Friday, January 20, 2017

Strong Doesn't Always Mean Better

     There has been a ton of talk about the strength of the dollar recently. Some people who don't know so much about it might automatically think that strong would be good. The dollar must be doing great and everything is coming up roses for America. That's how I was a little bit ago before I finally understood the basics of the foreign exchange. I'm just going to provide a very basic example of why the strong dollar isn't necessarily a good thing for some aspects of the United States.

     For this example, let's assume that $1 U.S. dollar can buy 20 Mexican Peso. (Close to accurate, not exact). As the strength of the dollar goes up Americans will be able to buy more Peso than before. In that way, importers are gaining a lot from this. They will have to use less of their money to buy the same amount of good.

                    $1 dollar = 20 Peso                  ==>          $1 dollar = 30 Peso

Now, when that importing firm needs to exchange their dollars for Peso's to buy from the Mexican company and they need 1200 Peso...

                    $1 dollar = 20 Peso                  ==>          $1 dollar = 30 Peso
               $60 dollars = 1200 Peso          ==>          $40 dollars = 1200 Peso

     On a much larger scale this is making a huge, huge difference to American importers. Everything is costing them less dollars to buy and it can go to helping their bottom line.

     However, this is an equal and opposite reaction to exporters. Looking at the example above and put yourself in the Mexican company's shoes. They are exporting the same amount of goods to the U.S. but receiving significantly less money for them. In 2014, the United States imported $2.19 Trillion dollars worth of goods and exported $1.45 Trillion. An excessive gap. Trump and his cabinet members have expressed an interest and intent to cut down on the export/import gap. How do they figure they do this with the strength of the dollar continuing to rise? Trumps pick for Secretary of Treasury, Steven Mnuchin, said the other day that though in the short term the dollar may be too strong, he advocates for stronger dollar over the long term. 

     Obviously it isn't all bad. I get that. But when one of the main goals is to raise exports and close the gap between imports then it doesn't make a whole lot of sense. People from overseas importing from the United States will have to pay much more for their goods thusly decreasing the amount of imports. That makes the most sense.

     Having a strong dollar isn't always a good thing. In the case of increasing exports, then it is no good either. Also, foreign investors likely will be trading their own currency for that of the United States because interest rates are going to be rising and the return people can get, relatively risk free, will be higher. That action can continue to strengthen the dollar as well. 

     Pretty rough drawing here, but I'll explain this. Quantity is on the horizontal axis. As the foreign investors trade their money for US dollars they supply of their currency goes up, thus bringing the value of it (vertical axis) down. In the United States, the supply of the dollar will decrease as it is bought up in the FX market and bring the value of it up because the quantity is decreasing. In that way, the strength of the dollar can increase. The basic explanation.

Not always good. Not always bad, but not always good either. 

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