Econ 101: What Does a Falling Dollar Mean?

     The media have been concerned about the falling value of the dollar and what may be causing it. One example that hits close to home here in Michigan is that the U.S. dollar is now worth less than the Canadian dollar. This is akin to the Detroit Red Wings losing 8-0 to the Montreal Canadiens.

     But currency markets are much like the market for any other goods. If the supply of one currency rises relative to the demand for that currency, then its price will fall.

     How does this work in exchange rate terms? To follow with the Canadian example, Canadians need U.S. dollars if they wish to purchase goods and services from us and/or to invest in U.S. capital markets. If there are not many U.S. dollars available and there are lots of Canadian dollars, then it will take a lot of Canadian dollars to buy a U.S. dollar, and thus the exchange rate will result in a “strong dollar.”

     If there are a lot of U.S. dollars and not many Canadian dollars, then it will take few Canadian dollars to buy a U.S. dollar, and the dollar will be “weak.”

     Thus, what determines the value of the dollar is the same as what determines the value of any other freely traded product – the supply of it relative to the demand. So if one wants to know what is causing the changes in the value of the dollar, one needs to know what changes the demand for and supply of dollars.

     As suggested above, the demand for dollars is what economists call a derived demand. One doesn’t really want dollars for their own sake, but for the goods that dollars can buy. If everyone in Canada wanted to buy an Apple iPod, then they would need U.S. dollars to do so, and the demand for U.S. dollars would rise against the Canadian dollar. The same is true if Canadians wanted to buy U.S. stocks because our economy was booming relative to the Canadian economy.

     The supply of U.S. dollars is controlled to a major extent by the U.S. Federal Reserve. We have recently been experiencing an expansion of the money supply by the Federal Reserve. One result of this is that it takes more U.S. dollars to buy Canadian dollars, as the supply of U.S. dollars has risen relative to the supply of Canadian dollars.

     Notice, though, that there is an equilibrating mechanism at work. If the price of U.S. dollars falls, then U.S. goods and services as well as U.S. financial assets become cheaper in terms of Canadian dollars. This means Canadians are likely to want more U.S. dollars to buy these now-cheaper U.S. goods and assets. This will increase the demand for U.S. dollars and bid up the price of U.S. dollars. One of the strongest parts of the U.S. economy in recent months has been exports, just as the value of the dollar has been declining.

     Is there some correct price for the dollar? That is like asking if there is some correct price for pizzas. If you sell pizzas you would like their price to be high. If you buy pizzas you would like their price to be low.

     Likewise, if you sell U.S. goods in Canada you would like to have Canadian dollars be able to buy lots of U.S. dollars (a weak U.S. dollar), as it will increase the demand for your product. If you buy Canadian goods, you would like to have U.S. dollars able to buy lots of Canadian dollars (a strong U.S. dollar) and thus lots of Canadian goods.

     If the Federal Reserve increases the money supply so quickly that dollars fail to become a store of value, then the value of the dollar, both domestically and in foreign exchange markets, will collapse and inflation will soar. The Federal Reserve has sufficient knowledge of currency markets and economic theory that hyper-inflation is not a likely outcome.

     However, gold at $800 per ounce and a U.S. dollar below the value of a Canadian dollar is a sign that monetary policy may be sufficiently loose that inflation can become a problem in the relatively near future. Inflation – rather than its symptom in the form of a falling dollar – that is the real concern.

Dr. Gary L. Wolfram, a Business & Media Institute adviser, is the George Munson Professor of political economy at Hillsdale College in Hillsdale, Mich.