Thursday, February 7, 2008

Benefits and Costs of a Falling Dollar

Who Wins and Who Loses From the Depreciating Dollar?
An interesting piece here by Reuters showing that the Euro is now being accepted in New York shops. Euro accepted in New York

This is mostly a symbolic reflection of the declining power of the dollar. It also illustrates how attractive American goods have become to Europeans.
Because of the Dollar's weakness, European consumers can pick up many bargains by buying goods in the US. Especially, for electronic goods, Europeans can make savings of upto 60-70%. Although a falling currency often injures a sense of national pride; it is worth asking is a weak dollar really a big problem for US?

Benefits of A Devaluation for the US.

  1. Boosts Exports. The devaluing dollar has given a much needed boost to the US export industry. The export sector is one of the best performing parts of the US economy, creating jobs and boosting domestic demand.
  2. Reducing Current Account deficit. 12 months ago, the US were facing a current account deficit of over 6.5% of GDP. In the past few months, the devaluation of the dollar has helped to reduce the current account deficit to only 4.8%. (Although, one does have to wonder how far the dollar would need to fall to eliminate the current account deficit)
  3. Boost Economic Growth. With the US housing market experiencing severe problems such as falling house prices and rising repossessions, there are widespread fears the US could enter into a recession. The boost from net exports could be a significant factor in maintaining rates of economic growth.

Costs of Falling Dollar

1. Inflation. The main worry of a depreciating currency is the impact on inflation. Depreciation causes inflation because:
  • imports more expensive
  • Rising AD
  • Exporting Firms have less incentive to cut costs

However, the depreciation in the currency comes at a good time. Because of the slowdown in economic growth, inflation seems to be the least of the US's concerns. The Fed illustrated this by cutting interest rates by 1.25% in the past couple of weeks. Therefore, inflation is not really a problem

2. More expensive imports. the depreciating dollar is certainly bad news for American consumers and American tourists. They have found that a weak dollar is no joke when you go on holiday to Europe. However, given the low savings ratio and high trade deficit, perhaps it is good that American consumers lose their attraction for consuming so many foreign imports.

A continual depreciation in the US dollar will reduce living standards in America; there is also the possibility of declining competitiveness in the long term. However, the depreciation has come at an opportune moment. With the prospect of recession and large current account deficit, the weak dollar is ironically helping to make the US economy stronger. Although it is worth pointing out, it is making the economy stronger from the demand perspective; it does nothing to address the underlying problems facing the US economy.

Related essays on the dollar

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