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The average person perceives the value of currency as fairly stable from day to day. The price of a cup of coffee every morning is $1.50, the fixed-interest car payment and mortgage are the same every month, and for a salaried worker, even the paychecks are identical. The fact that the value of currency is constantly fluctuating in relation to other currencies only seems to matter for most people when planning a foreign trip or making an internet purchase from a foreign website. This limited view, however, is mistaken.
The indirect impact of exchange rates and their fluctuations extends much more broadly and deeper in ways that affect several of the most important aspects of our economic lives—like how long it takes to get a job, where we can afford to live, and when we can retire. Exchange rates have a tremendous influence on the economy both in the near term and over prolonged periods of time.
In this era of globalization, goods from other countries are as commonplace, or sometimes even more commonplace, than those produced domestically. Exchange rates have a significant impact on the prices you pay for imported products. A weaker domestic currency means that the price you pay for foreign goods will generally rise significantly. As a corollary, a stronger domestic currency may reduce the prices of foreign goods to some extent.
Let’s illustrate the impact of a weaker domestic currency on product prices with an example. Assume that the Canadian dollar (C$) declines by 10% against the U.S. dollar (US$) over the period of a year, from a rate of 90 U.S. cents per C$ (US$1 = C$ 1.1110) to 81 U.S. cents (US$1 = C$1.2350). What would be the price change in Canadian supermarkets for a pound of California almonds that are available in the U.S. for US$7? All else being equal (assuming no other costs and only taking exchange rates into account), the price of California almonds in Canada would increase from about C$7.78 (i.e., approx. US$7 x 1.1110) to C$8.65 (US$7 x 1.2350) per pound.
As another example, let's look at the effect of currencies and prices when more than one country is involved. For example, say that the euro tumbled more than 20% against the U.S. dollar over a one-year period. During the same time, say the Canadian dollar had also declined, but only by 10% against the U.S. dollar, by comparison. As a result, the Canadian dollar had actually appreciated about 15% against the euro over that year (e.g., from C$1 = EUR 0.65 to C$1 = 0.75), resulting in Canadians paying somewhat lower prices for European products such as wine and cheese.
The change in the price of imported products depends on how the currencies of the exporting nations (i.e., those from where these products have been sourced) have fared against the domestic currency. In 2014 and 2015 the U.S. dollar saw one of its largest ever appreciations against a wide range of world currencies which resulted in American consumers paying relatively lower prices for imports such as German automobiles or Japanese electronics.
A weak domestic currency can push up the inflation rate in a nation that is a big importer, because of higher prices for foreign products. This may induce the central bank to raise interest rates to counter inflation, as well as to support the currency and prevent it from plunging sharply. Conversely, a strong currency depresses inflation as a currency that is worth more requires less of it to purchase goods and services. High interest rates and a tight monetary policy are used to control inflation, but they exert a drag on the economy. To avoid this, once inflation is under control, a central bank will typically lower interest rates and loosen the monetary policy.
The exchange rate thus has an indirect impact on the interest rate you pay on your mortgage or car loan or the interest you receive on the money in your savings or money market account.
A weak domestic currency spurs economic growth by boosting exports and making imports more expensive (forcing consumers to buy domestic goods). Faster economic growth usually translates into better employment prospects. A strong domestic currency can have the opposite effect, as it slows economic growth and curtails employment prospects.
Exchange rate fluctuations can have a substantial impact on your investment portfolio, even if you only hold domestic investments. For example, the strong dollar generally dampens global demand for commodities as they are priced in dollars. This lower demand can affect earnings and valuations for domestic commodity producers.
A strong currency can also have an effect on sales and profits earned overseas; in recent years, numerous U.S. multinationals attributed a hit to the top-line and bottom-line due to a stronger dollar. Of course, the effect of exchange rates on portfolio returns is well known. Investing in securities that are denominated in an appreciating currency can boost total returns, while investing in securities denominated in a depreciating currency can trim total returns. For instance, say that European stock indices reach record highs while the dollar is strengthening quite aggressively against the euro. American investors who had invested in those European-listed shares could actually see their real returns reduced substantially by the unfavorable exchange rate.
A weak or undervalued domestic currency can be like having an open-ended Black Friday sale and what is marked down is every single good, service, and asset in a country. The trick is, only buyers who possess a stronger foreign currency get the sale price. This attracts foreign tourists, which can be good for the economy. However, it also attracts foreign buyers looking to scoop up cheap assets and outbidding domestic buyers for them.
Foreign buyers have pushed up housing prices in nations with a weak currency. Imagine you are house hunting and suddenly you are bidding against people who are getting, say, an automatic 30 percent discount on the asking price. Even if you are not house hunting, high housing prices and low supply affect rent as well. Within a country's domestic market, low interest rates, often imposed to stimulate an economy, tend to boost housing demand. This can lead to prices being pushed up if housing stock doesn't keep up.
Low-interest rates also tend to cause a decline in a currency's value. If multiple nations seek to devalue their currencies with low rates and other measures, a currency war could ensue. Currency wars are often a battle over making one nation's exports more competitive than goods from its currency war opponent or opponents.
Just like an iceberg, the major impact of exchange rates fluctuations lies largely beneath the surface. The indirect effect of currency fluctuations dwarfs the direct effect because of the huge influence it exerts on the economy in both the near term and long term. The indirect effect of exchange rates extends to the prices you pay at the supermarket, the interest rates on your loans and savings, the returns on your investment portfolio, your job prospects, and possibly even on housing prices in your area.