Businesses engaged in foreign trade are acutely aware of the effects of currency fluctuations. In some cases, such movements provide certain advantages, while other times, the effects can devastate the business. Because of the potential damage that can occur when a currency depreciates, some businesses forgo the effects altogether by utilizing risk management techniques, such as hedging.
Depreciation occurs when a nation’s base currency becomes weaker with respect to another country’s currency. The dollar loses strength when the money supply increases, which may happen for a number of reasons: The Federal Reserve lowering interest rates and countries selling its dollar reserves are examples of two such instances. Countries sell dollars when confidence in the U.S. economy is low. When the dollar depreciates, it becomes cheaper for other nations to buy dollar-denominated assets.
Effects: Export Sellers
If a U.S. business specializes in selling exports, dollar depreciation causes its products to become cheaper to foreign clients. Thus, foreign demand for U.S.-produced goods and dollar-backed assets rises. As explained by Simon Kennedy in a May 2011 “Wall Street Journal” article, the weak dollar is the reason why the prices of commodities such as oil and grains have increased. However, prices for Americans increase on account of the inflationary effects of depreciation. Americans incur higher prices if exporters start charging higher prices for their goods based on the increased demand from overseas as well.
Effects: Export Buyers
If U.S. consumers of a country purchase exports from other countries, depreciation in the dollar causes Americans to purchase fewer goods from abroad and, instead, purchase more domestic-produced goods. This is because imports become more expensive when the country’s currency depreciates. For example, Roger Arnold, author of “Economics” explains that American car companies will experience a boost in sales in the short-run as more Americans buy domestic cars instead of more-expensive foreign cars.
If the overall economy is strong, the effects of currency depreciation typically occur in the short-run. Market forces naturally cause currency to appreciate again in the long-run. When the dollar grows weak, countries capitalize on the opportunity to buy more dollars. Purchasing dollars from the market, however, causes the currency to appreciate again. The Federal Reserve may also choose to stabilize the dollar if there are too many adverse effects from depreciation. Michael Shenk of the Federal Reserve Bank of Cleveland explains the Fed may appreciate the dollar in the short-run with a “sterilized sale” or buy a foreign currency with dollars.