Tuesday, April 24, 2007

Value of the dollar

A few days ago, an American living in Uruguay asked me to explain why the value of the dollar had dropped. It's a great question but I didn't have a great answer or, more accurately, I had too many answers.

Explaining exchange rates, in one sense, is very simple: the value of the dollar depends on supply and demand. Supply comes from people who are willing to sell dollars and demand comes from those who are interested in buying dollars. The value of the dollar adjusts to balance the desires of the buyers and sellers.

This gives us two possible explanations for a drop in the value of the dollar-- an increase in the supply of dollars or a decrease in the demand for dollars. While true, this isn't very profound and unless you're studying for an economics 101 exam it's probably not very interesting. We can use this simple model, however, to look for some explanations.

Why would someone want to have dollars? You can't eat them or drink them. You can't wear them, drive them, or live in them. No, the value of the dollar is indirect. People want dollars because those dollars can be used to buy real goods and services. So, at least partially, the demand for dollars comes from people in other countries who want to buy things priced in dollars-- stuff from the US-- a tractor from John Deer, a copy of Microsoft Windows, accounting services from Ernst & Young, a trip to Disneyworld, a US Treasury bond, or stock in Google.

Let's turn to the supply of dollars to the international currency markets. Unlike the supply of an ordinary product, the supply of dollars isn't based on the physical cost of producing currency. Dollars are supplied by people who want to buy something from another country-- a Mini Cooper, a Nokia phone, a villa in Tuscany, Mitsubishi stock, or a diamond mine in Botswana.

We're basically looking at imports, exports, and international flows of capital. When the US imports more goods and services than it exports-- a trade deficit-- it depresses the value of the dollar. Capital flows into the US (foreign purchases of US stocks, bonds, and other assets) can offset that downward pressure. In the last few years, the US has had record trade deficits. These have been mostly balanced by foreign purchases of US treasury bonds, particularly by Asian central banks. But the appetite for US debt isn't endless, so the value of the dollar depreciates.

Have I left anything out? Sure. I should probably discuss speculation, risk, interest rates, relative inflation rates, purchasing power parity, reserve currencies and more. But those will have to wait for another day.