The Fluctuating Dollar

Most people think of the U.S. dollar in terms of what it purchases in their local communities, or in terms of domestic inflation eroding its purchasing power. However, the dollar is also subject to international economic forces, and its value constantly rises and falls against them.

The strength or weakness of any currency relative to another currency is generally believed to reflect the relative strengths of the two countries' economies. For example, 25 years ago, a dollar was worth approximately 360 Japanese yen; by 1994, the dollar had dropped to about 100 yen. The sharp decline of the dollar relative to the yen reflected the tremendous economic growth in Japan at that time and the high level of Japanese exports to the United States.

When the U.S. dollar declines against another currency, it means that a dollar can be exchanged for less of that currency. Imports of goods made in that country then become more expensive, as does travel to that country. For example, if a dollar is worth 2 marks and lunch in a German restaurant costs 22 marks, that translates to an $11 lunch. If the dollar falls to 1.65 marks, the same lunch now costs $13.33 (22 divided by 1.65).

A weaker dollar also means that U.S. exports are cheaper than similar goods in countries with stronger currency. This might seem like a positive effect, but it doesn't always work out that way: some countries, such as Japan, have protectionist strategies that prohibit imports of certain products, even if those imports are cheaper.

The effect of a weak dollar at home is more subtle. The United States borrows money from other countries to help cover annual budget deficits, financing it through the sale of Treasury bills, notes, and bonds. When the dollar weakens against foreign currencies, the U.S. must offer higher interest rates to retain foreign buyers of government securities. This may have the side effect of raising other domestic interest rates, including those on adjustable-rate home mortgages, auto loans, and business borrowing.

Currency exchange rates can give you insight into how one country's economy is faring compared to another's. The strength of the dollar affects many economic factors and can be an important indicator for numerous kinds of investments..