US Dollar and Foreign Exchange Rate | Academic Papers Help

US Dollar and Foreign Exchange Rate

The exchange rate between two currencies is the rate used in exchanging one currency for the other. The foreign exchange market is the body responsible for determining the exchange rates. It is ideal as the determining body since it is open to a wide range of different seller and buyer types and currency trading is continuous-operates 24 hours a day except on weekends. The theory of exchange can be applied in explaining the performance of the United States dollar in recent years. The exchange rate of the US Dollar shown in the exchange rate history chart expresses the performance of the dollar relative to the currency with which it has been paired in order for a specific comparison to be performed. The comparison is specific in that the way the dollar has fared against the Japanese Yen does not necessarily indicate its performance against the British Pound or the Swiss Franc. This paper will look at the performance of the US Dollar in recent years and how the theory of exchange rate explains it.
2.0 The US Dollar
The trading behavior of the US Dollar is closely monitored by investors and speculators all over the world since it is the de facto reserve currency globally. The entire global economy is exceedingly dependent on the US Dollar therefore it is almost impossible to overstate the dollar’s importance to the financial system of the world presently. The performance of the dollar in the international currency markets impacts enormously on American investors, foreign investors, and speculators. The behavior of the dollar has dramatic effects on bond markets, equity markets, interest rates, commodities and the international trade in the US (krugman and Obstfeld, 1994; pg. 41).
The late 1990s, which were the bubble years in US equities, were characterized by the US Dollar being in a magnificent bull market. By 2003, however, it had languished in a powerful bear market (Soederberg, 2004; pg 62). Over time investors have learnt that investment strategies that are successful in a major bull market turn tragic in a bear market. A bear market means a persistent downtrend that lasts longer than one year and is marked by series of lower interim highs and lows that are long. The time component here specified of one year or more is very crucial. A dominant trend is necessary for reliable conclusions to be made. An example is the typical flaring up of the powerful countertrend bear market rallies for only six to eight weeks whereas the primary downtrend has run for thirty seven months continuously.
The US Dollar Index is the most common way of measuring the value of the dollar in the world. It is a futures contract trading in the New York Board of Trade. The value of the US Dollar Index is not only attributed to its popularity but also its practice of comparing the US dollar to several global currencies instead of one only. Six currencies is the trade-weighted geometric average in the index presently. The European Euro dominates the index currently having 58% of the weight, the Japanese Yen follows at 14%, and then the British Pound at 12% and finally the Canadian dollar is the last at 9% (Delhaise, 1998, pg. 69). The legendary Swiss franc and the Swedish Krona share the remaining portion. Similar to the major stock indices, these weights change periodically but all the same the US Dollar Index still remains an ideal way of monitoring the performance of the US Dollar as a whole the world markets.
In early July 2001 the dollar had topped with a dollar-index level of 121 but it started plummeting (Soederberg, 2004; pg. 152). Soon, the dollar regained its composure and after September of the same year it started marching higher. By January 2002 it had climbed to 120 which is a slightly lower high. March 2003 saw the dollar close at 98, a level which had not been witnessed for more than three years. From then until April of 2003 the dollar continued a downward trend (Soederberg, 2004; pg. 146). This is well over the one year or more elements hence putting the dollar in that period in the bear market. A 19% decline of the dollar over a period of 21 months definitely points to a primary bear market.
3.0 The Foreign Exchange Rate
Today, though, the exchange rate is a common way of assessing the performance of the dollar. A number of methods can be utilized in determining the exchange rate. Dating as far back as the advent of widespread floating that was in the 1970s, no satisfactory explanation has been provided on the exchange rate movements especially the short- and medium term movements (Copeland, 1994, pg. 15). The US currency exchange value is influenced by business and economic factors. Interest rate differentials as well as the demand and supply of the US dollar are among the elements influencing its value. In order to keep the demand of the US dollar high, denomination of the price of oil is done in US foreign exchange. This particular strategy has contributed to the might of the US economy in the past. When the US dollar is strong, the US companies get a competitive advantage from the cost of imports or services derived from foreign countries (Delhaise, 1998; pg. 105). This advantage, however, has started to diminish in recent times.
4.0 Euro exchange rate against the dollar

Increasing pressure has been placed on the US currency exchange since the Euro was introduced. Alternative ways to price oil transactions have been investigated by a number of oil producing countries (Haggard, 2000; pg. 36). The Euro is becoming prominent in the economic stage worldwide. The realization by foreign countries, for instance Japan and china, that they are carrying a disproportionate amount of United States denominated foreign currency reserves has prompted them to diversify out of the US dollar. Consequently, the money exchange of the US has shown a gradual decline. Pressure on the US currency exchange rate has also increased due to the recent market turmoil. Foreign capital inflows are necessary in the US current account deficit for financing purposes. Due to the sub-prime mess of 2007, official interest rates have been cut in order to stimulate further investment in the stock market and encourage borrowing (Gosh et al, n.d.; pg. 62). In response to adverse fundamentals, the US dollar has continued free falling resulting from this reduction.
The demand for the Euro has prompted its rise against the dollar and other currencies such as the pound sterling, the Australian dollar, and the Canadian dollar. There is also the buoyant demand for commodities from developing countries like India and China which has led to a strong demand for commodity based currencies of Canada and Australia. Recently, the exchange rate of the US/Canada hit parity and the same direction seems to be followed by the Australian dollar. If the exchange rate of the US currency is to return to its former glory relative to other foreign currencies, major economic adjustments will have to take place globally.
The currency pair of the US dollar and the euro is a major one and among the most traded in the Forex markets. The importance of the euro exchange rate is not limited only to currency trades but applies also to governments in the Eurozone and other countries that have their national currencies pegged to the euro. There is also the comparison index created by the euro exchange rate vs. the dollar as a major indicator in comparing economic development of the European Union and the US respectively. The interest rates are the major tool for the governments in influencing the exchange rate of the euro against the US dollar. In the hands of the Central banks, this is a powerful weapon (Gosh et al, n.d.; pg. 62). However, the European Central Bank and the Federal Reserve use it cautiously. The European Central Bank would rather utilize different means possessed by the central bank governors than interfere directly in the Forex markets.
Economic development of participating countries as well as data on the Eurozone impact on the euro exchange significantly. The 14-month low recoded in May 2010 of the euro against the US dollar was attributed to the news on Greece experiencing serious financial troubles and rumors that financial stability of the Eurozone could be hampered by the financial aid for the country. The euro exchange against the dollar is also very volatile sometimes reaching up to 4% in a single trading day. In March 18, 2009 the euro exchange rate against the dollar recorded the biggest daily gain as a 3.9% jump by the common European currency against the dollar was stated by Reuters. Looking at the history of euro exchange rate vs. the dollar many gains and slumps are apparent. However, most analysts are of the view that the relative strength of the common European currency against the dollar will continue in short- and mid-term (Mitchie and Grieve Smith, 1996; pg. 119). The Forex market is sophisticated though and due to its volatility no forecast can be considered full-proof. This is one reason why Forex experts and economists all over the world closely watch the exchange rate of the euro and the US dollar.
5.0 Factors influencing the trend of the USA dollar
The exchange rate of the US dollar is influenced by a number of factors. Four main reasons are the balance of payment in the country, level of interest rates in the country in comparison to other countries, the rate of inflation and the health condition and rate of return for investment of the country’s economy. The other factors are often temporary such as oil prices, wars, political instabilities etc and are believed to be connected with the above four factors. The trend of the US dollar according to most economists is majorly dependent on the balance of international payments. This kind of view, however, is partial. Looking at the history the balance of international payment is seen to feature trade deficit and the US economy has been dominated by the current account deficit since 1970s (Ahluwalia, 2000; pg. 21). However, no plummet drop is apparent from the track of the US dollar’ circulation.
Two times since the implementation of the floating exchange rate the exchange rate of the US dollar stayed at a high. One time was during the reign of Reagan and the other during the reign of Clinton (Mitchie and Grieve Smith, 1998; pg. 29). In Reagan’s reign the trade deficit, current account deficit and federal budget deficit were all high so was the exchange rate of the US dollar. The high exchange rate resulted from the high interest rate which as triggered by the high deficit. The trade deficit cannot be considered a result of the change of exchange rate but rather a reason for the change. During Clinton’s rule the surplus was realized. The condition of international payment, though, had not been improved much because the private saving rate was low and the US dollar exchange rate was still strong. This is primarily because of the high interest rate, strong growth of the economy of the country and a low returning rate. In this way, existence of the balance of international payment for a long time would make it the decisive factor for the US dollar depreciation. There are however some other factors that would counteract the function of the balance of international payment and lead to the appreciation of the US dollar. This is a short or medium term tendency.
6.0 Sharp drop of the US dollar exchange less likely
For there to be a sharp US dollar drop the US dollar holders worldwide would have to sell US dollars in large amounts similar to the way during bank credit crisis depositors draw money from banks. What makes it less likely is the fact that the US economy still boasts the highest growth rate and is most competitive among the developed countries. Confidence of other countries in the economy of the US is still prevalent. There is also the fact that the role of the US dollar as a currency for international reserve has placed it as the natural defense for the dollar’s devaluation. Thirdly, foreigners hold a large amount of the US dollar hence selling the dollar. In addition, the safety and circulation of the other currencies such as the euro and the Japanese Yen are not better than that of the US dollar (Singh, 2000; pg. 121).
7.0 Prospects and Implications of a dollar crisis

Since early 2002 the value of the dollar in international exchange has been declining. In the five years since then, on a real trade-weighted basis, the currency has dropped by 29%. The depreciation took place in a moderate pace with a 3.0% to 4.0% drop yearly (Ahluwalia, 2000; pg. 44). Most recently however, the pace has accelerated for instance falling almost 10% in the period between January and November 2007. The acceleration of the depreciation raises the concern over a possible dollar crisis looming. A situation where an annual decline of the dollar by 15-20% yearly for a number of years is experienced would send a significant negative shock to the United States economy and consequently the global economy (Ahluwalia, 2000; pg. 160).
The risk of a recession is impeding were there to be a dollar crisis since the US economy is already facing problems following the ongoing housing price crisis (Islam and Chowdhury, 2000; pg. 137). Impact on the economies of the other countries would depend on what is going on in their respective nations at the time of the fall of the dollar. Foreign economies highly dependent on the export sales to the United States would substantially be impacted negatively. The prospects of a dollar crisis therefore raise some questions. One is to ask whether the dollar crisis will really occur. Secondly, the question of the macroeconomic impact of the crisis on the economy of the U.S. and the global economy is raised. Another would be whether there are policy responses that would counter adverse impacts.
8.0 How money affects trade

Billions of dollars were used to buy the United States in June 1998 when it stepped into the foreign currency market to buy Japanese Yen with the aim of stabilizing the value of the US dollar. Mexico also faced a currency in the year 1994 (Soederberg, 2004; pg. 116). Argentina’s crisis was in 2002. Currency values affect daily transactions, demand for goods produced, and the price of the products that people buy. In the case of people in one country entering into another country and purchase from firms in that country, they have to enter into another market first and buy the currency of the country that they are conducting transactions in. an example is when a merchandise buyer desires to purchase Sony CD players for a retail consumer electronics group. The buyer would best enter the foreign exchange market and buy Yen which would then be used to pay Sony since firms prefer to deal in their own currencies.
Similar to the way supply and demand shift in order to change the prices of products, constant shift in supply and demand of foreign currencies is also a strategy for changing the prices of currencies. The ‘price’ of money therefore changes with the change in demand for foreign currencies. The ‘price’ of foreign currency here referred is the known as the foreign exchange rate when termed in the United States currency. Depending on the international demand and supply for currency, changes in this ‘floating’ foreign exchange rate are observed daily. Several factors can be pointed as the cause for an increase in the demand for a foreign currency. The other nation’s products selling at a lower price than the domestic products would lead to an increase in the demand for imports by the consumers.
Rise in domestic incomes or the domestic inflation rates being higher than in other nations would raise demand for imports. When the interest rate of another nation is higher than the domestic interest rates, people may opt to invest in the securities of the other nation. When the products from a particular country are imported more by consumers or people invest in the securities of that nation, the currency of that country increases in demand. The increase in demand pushes the currency’s price higher therefore appreciating the currency or in other words raising the value of the currency.
Since consumers use the US dollar when buying foreign currencies, once the foreign currency demand increases, the supply of US dollar internationally increases proportionately. With the increase in the supply of the dollars, the dollar depreciates due to the fall in the exchange rate of the US dollar. Supply and demand of currencies and the relative values of currencies that result have the capability to affect the demand for exports and imports in the international market nowadays. An example is how having a strong dollar makes it valuable compared to other currencies since the other currencies appear expensive to the Americans. Since they can the currency more cheaply, the prices of the products in the country appear lower to them. Due to the low prices the demand increases in quantity. In this way it is clear why when the US dollar is strong, Americans buy more imports from foreign countries (Sodersten, 1994; pg. 62). It helps the US importers since buying goods at lower costs makes it possible for them to offer the products at a lower price. This then increases the product’s quantity demanded and increases the profits that they receive.
The strong dollar, however, impacts on the American exporters negatively. With a strong dollar, buyers from foreign countries find the dollar expensive and consider they have to give up more of their currency when buying the dollar (Sodersten, 1994; pg. 51). Consequentially the prices of products from America appear expensive. The quantity demanded of the American exports falls. The US exporters are therefore disadvantaged and are forced to lower their prices in order to attract demand for the products they offer. This in turn lowers their profits and in extreme cases forces some firms out of business entirely. A trade deficit is therefore seen in a strong dollar where the imports rise and the exports fall.
It is interesting to note that the changing exchange rates can self correct over time. For instance, with a strong dollar, America demands more pesos in order to buy more products from Mexico. Demanding more pesos results to the appreciation of the peso hence over time Mexican exports begin to appear as expensive more and more. Moreover, the supply of the US dollar is growing in the international market over this period therefore the value of the peso falls as the dollar appreciates. Over time imports become less attractive and since their currency gets stronger, exports become more attractive. At this point the dollar would be weak. In this situation the US exporters would benefit but the US importers would be impacted negatively. Trade surplus would then result from the rise in exports and fall in imports (Krugman, 1997; pg. 56). The situation is expected to again reverse itself over time as the foreign demand for US exports increases and forces the prices of American goods internationally to go up. The foreign countries again start to avoid demanding for products from the US.
9.0 Problems experienced in Foreign Exchange Rates

There are times when central banks are faced with the option of either lowering or raising the exchange rate in an exchange system that is floating. This arbitration on a semi-regular basis leads the system to be referred to as a ‘dirty float’. Such intercessions are brought about by several reasons. Primarily the intervention is applied by central banks in order to secure exchange rate variations. The decisions made on international trade and investments are very intricate once the exchange rate value is altering in a speedy manner (Ocampo, 2002; pg. 13). A reduction in the international activities of the traders and investors may arise when exchange rate varies in a rapid manner since they may become more indecisive regarding profitability of trades and investments. International traders and investors therefore pressure governments and central banks to interfere whenever exchange rate wavers.
The other reason for the interference of central banks is the repealing of the growth in the trade shortage of the country. When the exchange rate of a country mounts considerably, trade shortages happen to increase quickly. In case of a higher currency value, foreign goods and services seem fairly cheaper therefore inspiring imports whereas the domestic goods pose as costly therefore leading exports to plummet. A rising currency value is therefore expected to raise the trade deficit. When the trade deficit poses as a problem for the economy, the central bank intervenes from pressure to reduce the currency’s value in the FOREX market and consequently reversing the trade deficit that was on the rise (Miles and Scott, 2002; pg 78). The central banks have two ways through which they can influence the exchange rate. Interfering openly in the market by buying or selling currency is the direct method. An indirect approach would be the transformation of the domestic money supply.
10.0 Conclusion

Change in supply and demand of currencies leads to change in the values of those currencies. A strong dollar would make imports seem less expensive, lead to the increase in demand for imported products and consequentially the currency required purchasing them. Additionally, higher interest rates in foreign countries lead to an increased demand for the foreign currency when people buy that currency so that they can invest in the securities of the other nation. In this scenario, the exports would decrease in a strong dollar event since they appear more expensive when looked at in the eyes of a foreign consumer. A trade deficit hence develops from a strong dollar. A weak US dollar would affect the country in the opposite way. The differences in currency values have the capability to affect the ability of the nation to sell exports or buy imports and consequentially affect the standards of living. A currency crisis in foreign countries is therefore not only limited to those countries because it can affect the economy and lives of the other countries too.

11.0 Reference List

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Ocampo, J.A 2002, Reforming the International Financial Architecture: Consensus and Divergence, Oxford University Press, London.
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