1. US Dollar and Foreign Exchange Rate
US Dollar and Foreign Exchange RateThe 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 DollarThe 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
2. 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 RateToday, 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 dollarIncreasing 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
3. 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 dollarThe 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
4. 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 likelyFor 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 crisisSince 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 tradeBillions 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
5. 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
6. 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 RatesThere 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 ConclusionChange 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
7. therefore not only limited to those countries because it can affect the economy and lives of
the other countries too.11.0 Reference ListAhluwalia, M 2000, Reforming the Global
Financial Architecture, Commonwealth Secretariat, London.Copeland, L 1994, Exchange
Rates, and International Finance, Addison-Wesley, Boston.Delhaise, P 1998, Asia in Crisis.
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and Consequences’ , International Monetary Fund.Haggard, S 2000, The political Economy
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Internationalism, MIT Press, Massachusetts.Michie, J & Grieve Smith, J 1996, Managing the
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Wealth of Nations, Wiley, New Jersey.Ocampo, J.A 2002, Reforming the International
Financial Architecture: Consensus and Divergence, Oxford University Press, London.Singh, K
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