Question

The U.S. economy has been in an expansion for almost a decade. What is the effect of a strong domestic economy on the market for U.S. dollars?

Answer 1

The economy's performance is at the heart of the decision to buy or sell dollars. A strong economy will attract investment from all over the world due to the perceived safety and the ability to achieve an acceptable rate of return on investment. Since investors always seek out the highest yield that is predictable or safe, an increase in investment, particularly from abroad, creates a strong capital account and a resulting high demand for dollars.

With a strong economy, a country can attract foreign capital to offset the trade deficit. That allows the U.S. to continue its role as the consumption engine that fuels all of the world economies, even though it's a debtor nation that borrows this money to consume. This also allows other countries to export to the U.S. and keep their own economies growing.

When the U.S. exports products or services, it creates a demand for dollars because customers need to pay for goods and services in dollars. Therefore they will have to convert their local currency into dollars by selling their own currency to buy dollars to make the payment. In addition, when the U.S. government or large American corporations issue bonds to raise capital that are then purchased by foreign investors, those payments will also have to be made in dollars. This also applies to the purchase of U.S. corporate stocks from non-U.S. investors, which would require the foreign investor to sell their currency to buy dollars in order to purchase those stocks.

These examples show how the U.S. creates more demand for dollars, and that in turn puts pressure on the supply of dollars, increasing the value of the dollar relative to the currencies being sold to buy dollars.

Another factor contributing to the general strength or weakness of a currency is a country's interest rate. Simply, interest rates are the amount it costs to borrow money. The interest rate level is moved higher or lower by a country's central bank to either stimulate or slow down an economy. Higher interest rates impose a more costly fee to borrow money while lower interest rates lessen the fee and usually spur more borrowing (or access to cheap credit) in an economy.

When it comes to demand for a particular currency, however, the higher the interest rate usually means the higher the demand for that currency.

The strength of an economy can go a long way to boosting the strength of the nation's currency. A strong growth rate in a country will see a growing demand for products and services with better job prospects for workers as well as being an attractive destination for capital and investments.

In an economy like the United States, which is driven by consumer spending, expanding growth that produces more jobs and better wages will allow workers to feel wealthier and help to further stimulate the economy through domestic consumption. More growth can bring higher inflation rates and the expectations for interest rate increases. Foreign investment and demand from companies abroad can also play an important factor in boosting the local currency of a strong economy.