Question

Assume that an economic boom occurs in the United States, so that the United States has a much higher growth rate than other nations. What will happen to the exchange rate of the U.S. dollar?

Answer 1

When there is a economic boom in the United States with growth rate higher than other nations, the dollar will strengthen against other currencies.

To elaborate on the reason, it is important to note that when there is an economic boom, inflation also trends higher. This translates into contractionary monetary policy by the Federal Reserve and interest rates in the economy trend higher. On the other hand, other countries with relatively lower economic growth have relatively lower interest rates.

The two factors of strong economic growth and higher interest rate create demand for investments in the United States and foreign funds flow into the United States seeking to invest in an economy exhibiting higher growth and having relatively attractive return on investment (higher rates).

This increases the demand for dollars as foreign investors sell their currency and buy the dollar for investment within the United States. With relatively tight supply of dollar on contractionary monetary policies coupled with high investment demand for the dollar, the currency appreciates against all major currencies where growth is lower than growth in the United States.

A good example is a appreciation of the dollar against the euro since 2015. Interest rates trended higher in the United States on strong economic growth while interest rates have remained low in the euro zone as uncertain growth outlook sustains.