Friday, December 01, 2006

USD Slides, But It's Not All Bad

Yesterday, the dollar hit a 20-month low against the euro and a 14-year low against the pound. Over the past year, it has dropped 6.7% against a Federal Reserve index of seven major currencies.

As the graph above shows, the appreciation of the British pound from about $1.40 to almost $2.00 over the last 4 years (left scale), and the accompanying fall of the USD, closely follows the increase in the supply of dollars, measured by M1 (right scale). Supply of dollars goes up, the value of the dollar goes down, and it takes more dollars to buy a British pound. Simple. It shoudn't be any surprise that the significant increase in the US M1 money supply, because of expansionary monetary policy in 2001-2004 (bringing the Fed Funds target rate from 6% in 2001 to 1% by 2004), has led to a decline in the value of the dollar.

A falling dollar might sound bad, but there are many benefits:

1. Higher stock returns overseas in dollars, because of the appreciation of foreign currencies, see my post below.

2. Increased demand for US goods and services, because of the appreciation of foreign currencies, see this story in today's WSJ: "Shopping as the Dollar Drops: Europeans Flock to U.S. for Deals While the Pound and the Euro Soar; Scoring iPods, Tiffany, Nike Sneakers."
A hot destination for European travelers this winter: Minnesota.

At a Holiday Inn near the Mall of America, the giant shopping center just outside Minneapolis, foreign tourists shopped so much this week that the hotel had to set aside four guest rooms to hold their suitcases after filling up its baggage-storage room.

Europeans are flocking to U.S. stores for Christmas shopping because the dollar's weakness makes the U.S. look like a bargain basement to them. The British pound yesterday hit a 14-year high against the dollar, and the euro has hovered around historic highs, too.
3. A weaker dollar could help the U.S. deflate its ballooning trade deficit by making American goods cheaper abroad and foreign goods pricier for Americans. It also could help Treasury Secretary Henry Paulson fend off what he considers an alarming rise in protectionist sentiment. See WSJ article here.



At 12/01/2006 8:17 PM, Anonymous Anonymous said...

How would you respond to alarmists that say that there is imminent danger that the dollar could fall lower and never recover against other currencies, and that foreign investors would sell out of their US investments...and this would be a nmajor problem for the US and investments here in the US... is there any reason to take heed at a comment like this or is it just nonsense

At 12/02/2006 8:10 AM, Blogger Mark J. Perry said...

See this posting here on Cafe Hayek by Don Bourdreaux, it addresses your question.


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