What a stronger dollar means for the economy

With the U.S. dollar considerably strengthening against other major currencies in recent months, you might be wondering: Why is this happening?

The value of one currency against another is in large part a function of central bank policies in each country. If a central bank pursues loose policy -- low interest rates that increase the risk of inflation -- a currency will fall in value relative to the currencies of its trading partners. When a central bank tightens policy -- raises interest rates -- then the currency generally strengthens.

Thus, one reason for the dollar's strength lately is the expectation that the U.S. Federal Reserve will begin raising interest rates fairly soon as the U.S. economic recovery gains. Then question then becomes: How will a stronger dollar affect America's economy?

Let's look at exports first. On July 1, one euro could be traded for $1.37, but on Oct. 13, one euro got only $1.27 dollars, or about 8.5 percent less than before.

What does this mean for U.S. exporters? Suppose a good or service produced by a U.S. exporter costs $1.37 per unit. On July 1, that good or service could be purchased with one euro. But on Oct. 13, one euro would no longer be sufficient. It would then take 8.5 percent more euros to make that purchase.

So, a stronger dollar means U.S. goods become more expensive to foreigners, and that hurts exporters and those employed in exporting industries.

The opposite occurs for imports coming into the U.S. As our exports become more expensive for foreigners as the dollar strengthens, goods imported into the U.S. become cheaper for Americans. Thus, import prices ought to rise as the dollar becomes stronger against other currencies.

Economists summarize the overall impact of imports and exports on the U.S. economy through a measure called "net exports," which is simply the difference between exports and imports. The idea behind this measure is that exports add to the demand for U.S. goods and services because foreigners are buying goods and services produced here, while imports reduce the demand for goods and services because U.S. residents are buying foreign rather than domestically produced goods.

The difference between the two, net exports, summarizes the impact on the demand for U.S. goods and services. Since exports fall and imports rise when the dollar strengthens, net exports -- and, therefore, demand for U.S. goods and services -- should fall.

That's not good news for an economy struggling to recover. But it's exactly what should happen in an economy that's threatening to overheat and cause inflation. In that case, we want demand for goods and services to fall.

When the Fed begins to fear that the economy is approaching full employment and demand might be excessive and cause inflation, it raises interest rates to slow the economy. One way this happens is through a stronger dollar.

What monetary policymakers need to decide is whether participants in foreign exchange markets have misinterpreted the Fed's intentions about interest rates -- is the U.S. central bank really about to hike its policy interest rate? If foreign exchange traders are misreading the Fed, the solution is for it to do a better job of communicating, and we've seen many recent attempts from the more dovish members of the monetary policy committee to do just that.

How that affects the dollar's strength in coming weeks and months remains to be seen, but it's clear that an important faction within the Fed believes foreign exchange markets need to readjust their expectations for when the Fed might raise its interest rate.