Strength, value of U.S. dollar impacts economy, merchants

This article was provided by Timothy M. Reese, senior vice president of investments with A.G. Edwards & Sons Inc.

The U.S. dollar is an important currency in world markets and plays a major role in international commerce.

Not only is the U.S. dollar used for most of the trade with this country, it is also the preferred currency for trade in many other countries.

While fluctuations in the exchange rates are reported in the press, many investors often overlook how changes in the value of the dollar itself can have significant bearing on our own investments here at home.

First of all, to understand how changes in the dollar affect our own economy, investors need to be aware of how those changes come about.

Since the early 1970s, the dollar has been allowed to "float" against many other currencies. This means that the actual value of the dollar is set in free markets governed by the laws of supply and demand.

Consequently, when other countries want more dollars to buy U.S. goods, services or assets, the value of the dollar will generally rise relative to the value of foreign currencies. If, on the other hand, the demand for the dollar shrinks, then its value tends to decline and the dollar weakens.

Sometimes a strong dollar is good because it dampens inflation by making imports less expensive.

At other times, when the economy is weak, then a weaker dollar can be a good thing. A weak dollar helps American manufacturers by making their goods more competitively priced when compared with foreign imports. When a dollar can't buy as much abroad, it makes imported goods, in effect, more expensive.

The resulting higher import prices tend to lead companies and consumers to purchase more domestic goods. This can give U.S. companies a competitive pricing advantage, just when the economy is weak and U.S. businesses could use a little extra help.

To illustrate this point, let's look at an example.

Confronted with the choice between an American-made watch and a foreign brand model, both priced at $100, consumers have a decision to make based mostly on product features and function. However, if the value of the dollar declined in the foreign marketplace, the store selling those watches would not be able to purchase the foreign model at the same price.

Consequently, the amount of money in dollar terms needed for the retailer to acquire foreign-made watches would increase.

As a result, the price for the consumer would go up as well.

If the store has to sell that same foreign watch for $103, customers may decide to go with the American product simply because it now carries the lower price tag.

On the other hand, the opposite is true when the value of our currency appreciates due to higher world demand for the dollar. Keep in mind that the value of the dollar in the world marketplace is based on supply and demand of the dollar itself. If that value increases, American consumers and business that buy goods, services or materials from abroad are the ones who benefit from increased purchasing power of their dollars.

Going back to the watch example, an appreciated dollar could buy more foreign products. If the retail price of the import watch drops to $95, consumers may be lured away from the American made goods simply because of the cost savings.

Granted, this is an extremely simplified example.

But it demonstrates the idea that a declining dollar can benefit domestic products and producers, while a rising dollar benefits those who purchase foreign goods.

A strong dollar does hurt domestic producers who try to sell abroad, such as farmers and manufacturers. But one of the benefits of a strong or appreciating currency is that it helps to keep domestic inflation in check, while a weak or depreciating currency tends to increase the chances of inflation.

When the economy struggles, the value of the dollar may drop, but the weaker dollar leads to future benefits by making the price of American products much more competitive in the world markets. As a result and barring an overly extended decline in the dollar U.S. businesses could regain market share they may have lost to cheaper imports.