Should America Want a Strong Dollar?

A strong dollar benefits importers, but hits exporting industries and emerging market economies

A rise in the dollar

The US Dollar is the most widely held reserve currency across the world. Hence, it plays a massive role in the stability of domestic and overseas markets. Emerging economies rely heavily on the dollar for its imports and US debt that it owns. China holds dollar reserves to devalue its own country and maintain its prosperous exporting industries. Though, is a rise in the dollar desirable for American citizens themselves?

A rise in the US dollar might benefit American residents when the reason behind the rise is positive. For example, the discovery of new oil reserves or natural resources is likely to benefit residents. Consumers will benefit due to lower commodity prices and consequently higher disposable incomes. Locals may also receive employment opportunities involved in extracting the new findings. American producers will also see their costs fall while having the opportunity to increase global supplies. On the other hand, locals may complain, especially if extraction methods are loud, polluting, and unsightly. Despite this, a positive economic shock that leads to a rise in the US dollar is likely to benefit most Americans.

A rise in the US dollar might harm American residents when the reason behind the rise is negative. For example, if the Fed is inducing a deflationary recession, citizens are likely to suffer. Artificially high interest rates increase the cost of borrowing, which can cause out of depth families to default on loan payments, particularly mortgages. These high interest rates also extract demand from the economy due to lower disposable incomes, putting jobs at risk, and firms may experience bankruptcy. On the other hand, banks may thrive since they earn wider margins and higher interest payments on their short-term holdings. Despite this, artificial interest rate policy by the Fed is likely to harm many Americans.

To conclude, a rise in the US dollar is desirable for importers and seems to favour richer Americans. Hence, poorer households benefit more from a falling dollar, since they are often employed in production industries, whereas richer Americans would prefer a rising dollar to assist their large investment portfolios.

Persistent overvaluation

A swelling US current account deficit has meant that the dollar is increasingly overvalued. But what are the other factors that have caused this persistence in its valuation?

The dollar may be persistently overvalued due to America’s renowned prosperity and robustness. A stable democracy coupled with a credible central bank creates a positive sentiment surrounding the dollar that investors cannot resist. Trust goes a long way, especially when governments, firms, and households are looking to hold their hard-earned wealth somewhere, and the US has earned this trust through years of repayment of government bonds. Hence, the demand not only for dollars, but US government bonds and financial products remain elevated, leads to an elevated exchange rate. Throughout the years, the accumulation of this trust maintains the dollar’s overvalued status, resulting in persistent overvaluation.

The dollar may also be persistently overvalued because it was the anchor currency in the post-war Bretton Woods agreement, which meant other economies bought up dollar reserves to maintain their fixed exchange rates since the dollar has been considered the default reserve currency for economies to hold. The explicit assignment of the dollar as the anchor currency has created this status quo bias where investors fail to consider other reserve currencies as alternatives. Thus, this status quo bias and the resulting herd behaviour have meant that people consider the dollar as the only reserve currency, which has led to its persistent overvaluation.

The dollar may also be persistently overvalued due to its network externalities. The rise of American firms and globalisation has meant that many deals and invoices are denominated in dollars. Trade-in goods and services, along with accounting standards and expectations, favour the dollar since it is widely recognised. It is convenient for businesses to work in dollars for simplicity. Therefore, the network externalities may not have caused the initial overvaluation of the dollar but instead have led to its persistent overvaluation as it has become easier and simpler for businesses to use.

To conclude, the Bretton Woods agreement is likely to be the initiator of the overvaluation of the US dollar. America’s economic prosperity and stability enforces its persistence. Finally, the network externalities that rose due to the previous two factors have maintained this overvaluation. Therefore, the dollar becoming persistently overvalued is complex since an initial rise is followed by factors that enable this valuation to persist.

Bretton Woods System and Agreement

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Ted Jeffery

Ted Jeffery

A student passionate about economics and how the world works. New blog post every Monday.

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