January 29, 2018

Understanding a "Weak" Dollar

David Beckworth

Senior Research Fellow

During a World Economic Forum panel in Davos last week, US Treasury Secretary Steven Mnuchin surprised observers by saying “a weaker dollar is good for us as it relates to trade and opportunities.”

Why it matters: Treasury Secretaries are historically supportive of a “strong” US dollar, and many observers were surprised by the comments. The value of the US dollar affects several aspects of the economy, both within the United States and globally.

Q&A with Economist David Beckworth

What does it mean when the dollar is ‘strong’ or ‘weak?’

There are several ways to think about the strength of the dollar. One approach is to ask how much value the dollar has gained or lost against a basket of currencies for our trading partners. According to this approach, the dollar grew 27% between mid-2014 and early 2017. That is fairly rapid growth by historical standards. Since early 2017, this measure of the dollar has fallen about 9%.  So the dollar is roughly 16% higher than it was in mid-2014. This suggest the dollar might still be strong.

Another approach draws upon the ‘law of one price’ theory which says that prices of similar goods across the world should converge over time. The idea is that if goods are priced differently somewhere else in world, trade flows will adjust to make the costs similar. For example, if vehicles were cheaper in Europe we would start importing more European vehicles. The increase demand for European cars would also raise demand for the Euro and lessen demand for the dollar. The dollar, consequently, would lose value against the Euro and would do so until European vehicles cost the same as American cars in dollar terms. This is the ‘law of one price’ or ‘purchasing power parity’ (PPP) for the exchange rate.

Because of trade barriers and other obstacles, the change in trade flows can take a while and consequently the PPP theory does a better job explaining exchange rate movements better over long periods. It is not so good in the short run. Still, PPP allows us to infer whether a currency is overvalued or undervalued relative to where it is headed in the long run based on the ‘law of one price’ thinking. A popularized version of this is The Economist’s Big Mac Index.

It shows, using McDonald’s Big Macs and PPP theory, whether currencies are overvalued are undervalued relative to the dollar. Currently, it shows that all but three currencies are undervalued relative to the dollar. In other words, the dollar is overvalued relative to most other currencies in the world. So whether we take a pure empirical approach like looking at the value of the dollar against other currencies in recent years or use a more theoretical approach like PPP, the dollar does appear to be overvalued.  

Were you surprised by Secretary Mnuchin’s comments?

Yes and No. Yes, because speaking about the dollar requires diplomacy and tact. The dollar is main currency of the world with roughly 70% of other currencies tied to the dollar in some form. Also, there is about $11 trillion dollars of dollar-denominated debt that is the obligation of other countries.  Therefore, whatever happens to the dollar has huge repercussion for the rest of the global economy. So yes, on one hand, the Treasury Secretary could have been a bit more careful in how he made his comment about the dollar.

No, because the Treasury Secretary is stating facts about the dollar.  What he said should not be a surprise to most informed watchers of currencies.

How much control over the strength of the dollar does the administration have?

In a practical sense, very little over the short-run. Over the longer run, the Trump administration has more power. To the extent its economic policies raise economic growth that would strengthen the dollar. To the extent the Trump administration policies raise inflation rate over the long run that would weaken dollar. Where it all falls out is unclear. What we do know for now is that the dollar appears overvalued.