While the United States has always engaged in foreign trade, the 21st century trend toward globalization has made international markets more important than ever. Whenever there is a transaction involving different currencies, exchange rates become an issue. Purchasing foreign goods requires two transactions because you must have the right currency to pay for the goods you want before acquiring them.
If an American business wishes to buy products made in Europe, the buyer has dollars and the seller wants euros. That means the buyer must first purchase euros to pay for them. The price he pays for those euros -- the exchange rate -- is determined by the laws of supply and demand, which is based on the demand for imports and exports. Capital markets are a factor as well. If interest rates are higher in one currency zone than another, money will flow in that direction as investors take advantage of higher returns, affecting demand for that currency.
When the U.S. dollar is strong, foreign currency is cheap by comparison. Dollars can buy more euros and you can purchase more foreign-made goods with the same amount of money. On the other hand, if you are an exporter desiring to sell products in Europe, Europeans cannot purchase as many expensive dollars per euro and your exports are likely to diminish. Over time the strong dollar may weaken because its strength may induce more businesses to buy European goods. That increases demand for euros, which raises their value while lowering the dollar's value.
A weak dollar has the opposite effect. When its value drops against a foreign currency, imported goods become less affordable for U.S. consumers and demand for them may decline as a result. A lower dollar means foreign traders can buy more dollars with their euros. Since their purchasing power has increased, they can buy more American goods and U.S. exports increase. While a strong dollar is symbolic of national economic strength, a weak dollar helps stimulate international demand for American products.
When the dollar appreciates in value and imports rise, the effect on U.S. gross domestic product (GDP) is negative. Since net exports -- exports minus imports -- is a component of GDP, an increase in imports and a corresponding decrease in exports tends to restrain economic growth. A falling dollar has the opposite effect, raising exports and lowering imports. This provides stimulation for the economy.
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