Question

1. How does weak dollar affect the export-import relation and the overall economy?  Back your answer with outside research of what tools and tactics they use and any successful/ unsuccessful cases you can find.
2. Explain why an increase in the money supply can affect interest rates in different ways.

Answer 1

How does weak dollar affect the export-import relation and the overall economy?

A weak dollar means our currency buys less of a foreign country's goods or services. Prices on imported goods rise. Consumers must pay more for imports, and foreign travelers may need to scale back a vacation because it is more expensive when the dollar is weak. However, a weak dollar also means our exports are more competitive in the global market, perhaps saving U.S. jobs in the process.

When a large trading partner like China (our largest) artificially keeps its currency weak, it hurts the balance of payments, meaning its goods are cheaper than domestically produced products. Though a short-term boon for the consumer, a weak currency of a foreign competitor means U.S. manufacturers have trouble competing.

Conflicts over currency can (and have) led to trade wars where import tariffs are imposed in response to artificially weak currency of major trading partners. Trade wars are generally counterproductive, but sometimes politicians are more concerned with what plays well with the home crowd rather than what it means for the overall economy.

Strong Dollar

Most of the world's major currencies float in value relative to one another. The U.S. dollar is often the standard by which other currencies are measured. A strong dollar means that our currency buys more of a foreign county's goods. It can be good for consumers and international travelers because the things they want to buy (think electronics) and places they want to go are cheaper.

However, the downside is U.S. companies that sell goods to foreign customers suffer because, relative to a weaker currency, our goods and services cost more. It may mean U.S. producers are at a disadvantage in the global market.

It can lead to manufacturers moving plants to foreign countries with lower costs so that they can remain competitive. In short, a strong dollar can mean jobs lost in the United States.

Explain why an increase in the money supply can affect interest rates in different ways.

All else being equal, a larger money supply lowers market interest rates, making it less expensive for consumers to borrow. Conversely, smaller money supplies tend to raise market interest rates, making it pricier for consumers to take out a loan. The current level of liquid money (supply) coordinates with the total demand for liquid money (demand) to help determine interest rates.

More Money Available, Lower Interest Rates

In a market economy, all prices, even prices for present money, are coordinated by supply and demand. Some individuals have a greater demand for present money than their current reserves allow; most homebuyers don't have $300,000 lying around, for example. To get more present money, these individuals enter the credit market and borrow from those who have an excess of present money (savers). Interest rates determine the cost of the borrowed present money.

The money supply in the United States fluctuates based on the actions of the Federal Reserve and commercial banks. By the law of supply, the interest rates charged to borrow money tend to be lower when there is more of it.

However, market risk is another pressure on interest rates that influences them in a significant way. Economists call these dual functions "liquidity preference" and "risk premium."

The Impact of Risk Premium

Interest rates aren't only the result of the interaction between the supply and demand for money; they also reflect the level of risk investors and lenders are willing to accept. This is the risk premium.

Suppose an investor has excess present money and he's willing to lend or invest the extra cash over the next two years. There are two possible investments for his present money—one offering a 5% interest rate and the other offering a 6% interest rate.

It's not immediately clear which he should choose because he needs to know the likelihood that he'll be paid back. If the 6% seems riskier than the 5%, he may choose the lower rate or ask the 6% buyer to raise his rate to a premium commensurate with the assumed risk.