All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

What's going on with the dollar? Everybody seems to be interested, even my fifteen year old son. What better indicator of the much publicized globalization process could there be?

The bad news is that my experience suggests that exchange rates are not well understood. My son was certainly clueless and so are many of my students. The good news is that a considerable amount of insight into exchange rates can be gained with the use of a simple model that many will remember from your introductory micro and macro courses, a model which I used to describe to my son the 'Spring Break' theory of the dollar's decline.

At the heart of the 'theory' is the supply and demand model of prices. People seem to know the basics of supply and demand, even if they have never had an economics course. We have all been immersed in an economic system that has conditioned us to know instinctively that a decline in price can be caused by either an increase in supply or a decrease in demand. Once the dollar problem was translated into this model, I was confident that even my son who had no formal training in economics could understand what he was hearing.

First, however, we need the ground rules.

• the price of the dollar, what some would refer to as the value of dollar or the exchange rate, is the number of units of a foreign currency needed to buy a dollar (ex. 97 yen per dollar).
• the exchange rate is set in the international money market, something very much akin to the US stock market, where currencies are bought and sold to accommodate all transactions that cross national borders.
• a demand for dollars is generated every time someone anywhere in the world wants to buy US goods and services or US assets. The recent export of US rice to Japan or the purchase of US government 'mortgages' by investors in Germany are examples of transactions that would generate a demand for dollars since both the US government and the farmers producing the rice would like to be paid in dollars.
• a supply of dollars is generated every time someone in the US tries to buy goods and services and assets from abroad. Examples would be when we need to sell our dollars to buy French francs to buy the wine from France or to buy pounds to purchase stocks listed on the London stock exchange.

Now we were ready for the 'Spring Break' theory. He knew that in the past few weeks many of my students had joined the thousands of others headed to Cancun, Mexico for their Spring Break. Before leaving for break, however, these students had to 'buy' pesos which they would use while in Cancun to pay for their hotels, restaurant, and bar bills. Many will have 'bought' the pesos at their local bank with dollars which their bank will then take to the international money market where it will sell the dollars in order to buy the pesos needed by the students. But as we saw above, any decrease in the demand or increase in the supply of dollars will drive down the price of the dollars.

It should come as no surprise, however, that this is not the only 'theory' of the dollar's decline to have paraded before the American people in recent weeks. A few of the alternatives proposed, are listed below, but as we will see, they are variations on the same theme.

• Deterioration in the balance of trade deficit: to pay for the increase in imports which produces the trade deficit, Americans must sell dollars to buy the foreign currency necessary to pay for their imports
• Rapid growth outside of the US: US investors, seeking the highest rate of return on their money, are increasing their supply of dollars to purchase foreign currency which they need to finance their purchase of stock on foreign stock exchanges.
• Low interest rates in the US: foreign investors, seeking the highest rate of return on their money, are selling US government securities and buying foreign securities which generates an increase in the supply of US dollars.
• Kobe earthquake: demand for dollars by Japanese investors to buy US assets will decline as some of the investors decide to use their funds to help rebuild Kobe rather than buy US government securities.
• Loss in 'confidence' in the dollar: demand for dollars in the post W.W.II era remained high as foreign investors and central bankers preferred to hold their cash as dollars, but the rise of new economic super powers Japan and Germany has prompted both investors and central bankers to diversify their cash portfolio by selling their dollars to buy Japanese yen and German marks.

And then my son interrupted me: "So the dollar will rise next week as the students return from their spring break" I knew then that while he may have overestimated the Spring Break effect, he understood the essentials of supply-demand model of exchange rates, that he would be able to translate the 'causes' of the dollars decline into increases in supply or decreases in demand for dollars. I also knew that I could now move on to his next question: Why is everybody so concerned about the fall of the dollar? It was time to talk to him about how he was growing up in a very different world, a world where his economic well being could be influenced by movements in the exchange rate, where the US's integration into the world economy had reached the point where economic policy in this country is being held hostage by the exchange rate.

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