Strengthening and Weakening Currency

When the value of a currency rises, so that the currency exchanges for more of other currencies, the exchange rate is described as appreciating or “strengthening.” When the value of a currency falls, so that a currency trades for less of other currencies, the exchange rate is described as depreciating or “weakening.”

To illustrate the use of these terms, consider the exchange rate between the U.S. dollar and the Canadian dollar since 1980, in Figure 1(a). The vertical axis in Figure 1(a) shows the price of $1 in U.S. currency, measured in terms of Canadian currency. Clearly, exchange rates can move up and down substantially. A U.S. dollar traded for $1.17 Canadian in 1980. The U.S. dollar appreciated or strengthened to $1.39 Canadian in 1986, depreciated or weakened to $1.15 Canadian in 1991, and then appreciated or strengthened to $1.60 Canadian by early in 2002, fell to roughly $1.20 Canadian in 2009, and then had a sharp spike up and decline in 2009 and 2010. In May of 2017, the U.S. dollar stood at $1.36 Canadian. The units in which we measure exchange rates can be confusing, because we measure the exchange rate of the U.S. dollar exchange using a different currency—the Canadian dollar. However, exchange rates always measure the price (or value) of one unit of currency by using a different currency.

Figure 1. Exchange rates tend to fluctuate substantially, even between bordering countries such as the United States and Canada. By looking closely at the time values (the years vary slightly on these graphs), it is clear that the values in part (a) are a mirror image of part (b), which demonstrates that the depreciation of one currency correlates to the appreciation of the other and vice versa. This means that when comparing the exchange rates between two countries (in this case, the United States and Canada), the depreciation (or weakening) of one country (the U.S. dollar for this example) indicates the appreciation (or strengthening) of the other currency (which in this example is the Canadian dollar). (Source: Federal Reserve Economic Data (FRED) https://research.stlouisfed.org/fred2/series/EXCAUS)

In looking at the exchange rate between two currencies, the appreciation or strengthening of one currency must mean the depreciation or weakening of the other. Figure 1(b) shows the exchange rate for the Canadian dollar, measured in terms of U.S. dollars. The exchange rate of the U.S. dollar measured in Canadian dollars, shown in Figure 1(a), is a perfect mirror image with the exchange rate of the Canadian dollar measured in U.S. dollars, shown in Figure 15(b). A fall in the Canada $/U.S. $ ratio means a rise in the U.S. $/Canada $ ratio, and vice versa.

With the price of a typical good or service, it is clear that higher prices benefit sellers and hurt buyers, while lower prices benefit buyers and hurt sellers. In the case of exchange rates, where the buyers and sellers are not always intuitively obvious, it is useful to trace through how different participants in the market will be affected by a stronger or weaker currency. Consider, for example, the impact of a stronger U.S. dollar on six different groups of economic actors, as shown in Figure 2: (1) U.S. exporters selling abroad; (2) foreign exporters (that is, firms selling imports in the U.S. economy); (3) U.S. tourists abroad; (4) foreign tourists visiting the United States; (5) U.S. investors (either foreign direct investment or portfolio investment) considering opportunities in other countries; (6) and foreign investors considering opportunities in the U.S. economy.

Figure 2. How Do Exchange Rate Movements Affect Each Group? Exchange rate movements affect exporters, tourists, and international investors in different ways.

For a U.S. firm selling abroad, a stronger U.S. dollar is a curse. A strong U.S. dollar means that foreign currencies are correspondingly weak. When this exporting firm earns foreign currencies through its export sales, and then converts them back to U.S. dollars to pay workers, suppliers, and investors, the stronger dollar means that the foreign currency buys fewer U.S. dollars than if the currency had not strengthened, and that the firm’s profits (as measured in dollars) fall. As a result, the firm may choose to reduce its exports, or it may raise its selling price, which will also tend to reduce its exports. In this way, a stronger currency reduces a country’s exports.

Conversely, for a foreign firm selling in the U.S. economy, a stronger dollar is a blessing. Each dollar earned through export sales, when traded back into the home currency of the exporting firm, will now buy more of the home currency than expected before the dollar had strengthened. As a result, the stronger dollar means that the importing firm will earn higher profits than expected. The firm will seek to expand its sales in the U.S. economy, or it may reduce prices, which will also lead to expanded sales. In this way, a stronger U.S. dollar means that consumers will purchase more from foreign producers, expanding the country’s level of imports.

For a U.S. tourist abroad, who is exchanging U.S. dollars for foreign currency as necessary, a stronger U.S. dollar is a benefit. The tourist receives more foreign currency for each U.S. dollar, and consequently the cost of the trip in U.S. dollars is lower. When a country’s currency is strong, it is a good time for citizens of that country to tour abroad. Imagine a U.S. tourist who has saved up $5,000 for a trip to South Africa. In January 2008, $1 bought 7 South African rand, so the tourist had 35,000 rand to spend. In January 2009, $1 bought 10 rand, so the tourist had 50,000 rand to spend. By January 2010, $1 bought only 7.5 rand. Clearly, 2009 was the year for U.S. tourists to visit South Africa. For foreign visitors to the United States, the opposite pattern holds true. A relatively stronger U.S. dollar means that their own currencies are relatively weaker, so that as they shift from their own currency to U.S. dollars, they have fewer U.S. dollars than previously. When a country’s currency is strong, it is not an especially good time for foreign tourists to visit.

A stronger dollar injures the prospects of a U.S. financial investor who has already invested money in another country. A U.S. financial investor abroad must first convert U.S. dollars to a foreign currency, invest in a foreign country, and then later convert that foreign currency back to U.S. dollars. If in the meantime the U.S. dollar becomes stronger and the foreign currency becomes weaker, then when the investor converts back to U.S. dollars, the rate of return on that investment will be less than originally expected at the time it was made.

However, a stronger U.S. dollar boosts the returns of a foreign investor putting money into a U.S. investment. That foreign investor converts from the home currency to U.S. dollars and seeks a U.S. investment, while later planning to switch back to the home currency. If, in the meantime, the dollar grows stronger, then when the time comes to convert from U.S. dollars back to the foreign currency, the investor will receive more foreign currency than expected at the time the original investment was made.

The preceding paragraphs all focus on the case where the U.S. dollar becomes stronger. The corresponding happy or unhappy economic reactions are illustrated in the first column of Figure 2. The following feature centers the analysis on the opposite: a weaker dollar.

At this point, you should have a good sense of the major players in the foreign exchange market: firms involved in international trade, tourists, international financial investors, banks, and foreign exchange dealers. The next section demonstrates in more detail how the tools of demand and supply can be used in foreign exchange markets to explain the underlying causes of stronger and weaker currencies.