Is the falling dollar good for the economy?

August 28th, 2008

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In the financial news media, we often hear reports that give the impression that the fall of the dollar (whether US dollar or the Australian dollar) is good for the economy because it benefits exporters. In reality, this is only half-true- exporters may benefit, but it may not be necessarily be good for the economy as a whole.

To see why, take a read at Chapter 6 (The Depreciation of the Mark and Germany’s Foreign Trade) of this book, The Economics Of Inflation- A Study Of Currency Depreciation In Post War Germany written by Costantino Bresciani – Turroni, an economist who lived through the German Hyperinflation of the 1920s:

The relations between exports and production deserve to be considered in greater detail. Three principal cases may be considered:

  1. The increase of exports of a given article, which is the consequence of the divergence between the internal and external values of the national money, is not followed by an increase in the production of that article. The rise in exports signified in this case a corresponding fall in the quantity formerly consumed at home.
  2. The possibility of increasing the exports of a given article provoked an increase in the production of it, but at the expense of other articles, the export of which is less attractive. On the whole, the production of the country is not increased; only the direction of economic activity is changed.
  3. The rise in exports is accompanied by an increase in the total production of the country with a depreciated currency.

Before we continue, we must first explain the concept of internal and external value of a currency. Basically, the internal value of a currency is its purchasing power domestically. Let’s say an apple cost 1 dollar domestically. This is the internal value of the dollar. Let’s say an apple cost 2 marks in a foreign country and the exchange rate is 1.5 mark for 1 dollar. Therefore, the cost of an apple overseas is 1.33 dollar. This is the external value of the dollar. In this example, the internal value of the dollar is greater than its external value.

Let’s say the dollar depreciate in value. As a result, there is a divergence between the internal and external value of the dollar. Since in the short term, the domestic economy cannot increase its production, effect (1) will be the result. In other words, using the example above, domestic apples will be exported, resulting in less apples domestically. The outcome is price rise for domestic apples. As Costantino explained,

The first case appears when a divergence between the internal and external values of money occurs suddenly and after a short time stops. The influence of that divergence is shown only in the sale of goods already in the warehouses; given the brief duration of the phenomenon, production in general does not feel it.

In the longer term, either effect (2) or effect (3) will be the outcome. That will depend on the situation of the domestic economy. Let’s say the economy has plenty of spare capacity. Perhaps there are far too many unemployed apple growers and land laying idle. In that case, all these idle resources will be put to work to produce more apples, which will raise national income. The nation becomes wealthier as a result. This is effect (3). As Costantino explained,

On the other hand, in a country where only a part of the machinery is occupied and where there is a considerable number of unemployed, a depreciation of the exchange, by stimulating foreign demand, can really provoke an increase in the total production.

What if the economy’s productive capacity is completely used up and can no longer increase its production of apples? In that case, the economy has to free up resources in order to produce more apples. This may mean that for example, clock makers may have to change their professions into growing apples. This means a restructuring of the economy whereby some industries will have to decline in order for the export industry to expand. This is effect (2). As Costantino explained,

But in a country where plant is already fully occupied, where unemployment does not exist, and where available resources are scarce, the effects on total production cannot be very considerable. If the divergence continues, a displacement of production is slowly produced: capital and labour move towards the production of those goods for which the divergence [in the internal and external value of the domestic currency] is most conspicuous.

In the next article, we will apply these insights into the study of real-life economies.

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