Economics Stripped: Dollar Deconstruction Part 2



Jenn Carey

Last week’s “Dollar Deconstruction” put the value of the dollar into perspective over time. Now it is time to consider the value of the present dollar relative to other currencies. If, for instance, a Colgate student wanted to buy an overseas product from China (imagine for a moment that you cannot just go to the nearest Wal-Mart to do so) valued at 13 yuan, the student would have to pay roughly two dollars at the current dollar value in order to make this purchase. Just as the value of the dol­lar historically has not been static, the exchange rate of the dollar undergoes change almost as frequently as does Joan Rivers’s nose. The increasing or decreasing value of the American dollar has important implications for consumer purchasing power. Suppose that the value of the dollar decreases relative to the euro – now rather than one dollar equating to 0.7 euros, one dollar only equates to 0.5 euros. Thus, purchasing foreign goods has become more expensive for the American consumer, since they now have to cough up more dollars to pay for an item priced in euros. However, for the European consumer, American products have become easier to purchase now that the euro is stronger in relation to the dollar. So, if someone was in the market for a pricey international purchase – say, a mail-order bride – when the dollar is strong he will get more bang for his buck – no pun intended.

One mechanism that can alter the value of the dollar is monetary policy, which produces a domino effect in the money market. While many Colgate students do not seem to understand cause and effect (cause: drinking 4Loko, effect: enough compromising Facebook photos to prevent you from ever running for political office), understanding monetary policy comes from understanding the sequential effects of Federal Reserve actions. The Federal Reserve banks across the nation are responsible for placing money into circulation. The Fed’s decision to augment or curb the money supply depends on the desired outcome in the economy. If, for instance, the Fed wants to stimulate consumption and investment, they will cause more money to be put into circulation. This relationship is not necessarily intuitive.

When the Fed increases or restricts the money supply, the nominal interest rate, or the “federal funds rate” increases or declines accordingly. Since interest rates signify how costly it is for an individual to take out a loan, logically, this individual will be more inclined to borrow when the interest that they have to pay back – in addition to the initial loan amount – is low. If the Fed places more dollars into cir­culation, the interest rate, or “federal funds rate” for the jargon junkies, goes down. This means that if an individual was considering taking out a loan to buy a car, the amount of interest he or she will have to pay back on that loan just became smaller. Presumably, the rational individual will be more likely to purchase the vehicle un­der these conditions, thus causing the aforementioned growth in consumption. The Fed often “targets” a certain level for the federal funds rate that they hope to achieve – however, just like a Colgate student who intends on making it to Case by 10 a.m. Saturday morning, the best laid plans often go awry. In the wake of the financial crisis, the federal funds rate was continually set at lower and lower targets with the hopes of stimulating consumption, ultimately hitting a rock bottom target rate of zero percent.

So just what does monetary policy have to do with the value of the dollar in an international setting? The dollar is stronger when interest rates are higher and weaker when interest rates are low. If the interest rate is high in America, individu­als overseas recognize their potential to profit from accruing interest on American investments or holdings. As a result, individuals abroad will want to have more American money at their disposal. Using the basic principles of supply and de­mand, greater desire abroad for American dollars causes demand to exceed supply. This results in the escalating value of the dollar and, thus, stronger American cur­rency. As promised, let’s return to Angelina and Brad for an example. If the value of the American dollar continues to plummet against the value of Namibian currency, the U.S. dollar is not only less appealing, but also less powerful in Namibian mar­kets. If Brad and Angie want to adopt another child, they will have to pay more out of pocket when the dollar is weak than if the adoption fees had been handled in a time of relative American dollar dominance. However, perhaps the Jolie-Pitts have bigger problems. Economic woes aside, Brad and Angie will also face the struggle of finding yet another unique name for their latest family member – and with “Pilot Inspector” off the market, this may be a daunting task.