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I flew to Berlin for a vacation last month with friends. We had an amazing time, drinking Radlers on public transit, dancing in techno clubs, visiting historic sites, eating late-night döner kebabs and appreciating the incredible street art that covers every surface in the city. It was ridiculously fun — and fortuitously timed, given the current economic situation.
Let me be clear: I spent a lot of money in Berlin (those ampelmännchen souvenirs weren’t going to buy themselves, you know). But when I was paying the cashier at the local späti, forking over Euros for beers, I began to truly think about the value of my U.S. dollars.
Though I vaguely remembered hearing economists refer to the quote-unquote "strength of the dollar" in the past, it always seemed like an abstract concept. I’d never actually experienced it for myself. Now that I’m back on American soil, I’m ready to investigate.
What does it mean when people say the dollar is strong?
I called Robert Barbera, director of the Center for Financial Economics at Johns Hopkins University, to get a layman’s explanation. Barbera says that what I encountered in Berlin had to do with the bilateral exchange rate, or the rate at which I can swap one currency for another.
Say I want to buy a BMW. (A girl can dream, right?) It was manufactured in Germany, got shipped to the U.S. and costs 50,000 Euros. If, at the moment I’m purchasing the car, the exchange rate is 1:1, $1 buys €1. I can go to the bank, swap $50,000 for €50,000 and purchase my car.
But say the dollar is "strong," which means it’s appreciating in value like it is right now. For example, if the dollar is up by 20%, I’ll be able to get €1.20 for $1. So when I buy my BMW, it’s effectively at a discount — even though the sticker price hasn’t changed.
"When the dollar goes up, it means stuff we buy from the rest of the world gets cheaper,” Barbera says.
At one point this month, the U.S. Dollar Index, which compares the dollar to a basket of six foreign currencies, passed 105 — the highest it’s been in roughly 20 years.
This appreciation is likely due to America's record-setting inflation... and the Federal Reserve's decision to hike interest rates as a means of controlling it.
It’s a chain reaction. When the Fed increases rates, the yields on U.S. Treasury bonds — a type of investment in government debt — also rise. And when "the rest of the world" realizes this opportunity exists, Barbera says, people flock to buy U.S. dollars.
The surging demand for dollars makes them more valuable. This results in a sweet deal for vacationing Americans, according to Toby Mathis, a tax attorney in Las Vegas. They may think, “Hey, I love that strong U.S. dollar because anything I buy is on sale,” he says.
(See: me in Berlin.)
It's not just that stuff Americans buy abroad is cheaper. Items imported into the U.S. become less expensive, which can mean that some of the stuff we buy here might get cheaper, too. Take Walmart, where an estimated 80% of items sold are made in China. When the dollar price for imports goes down, Walmart is able to pay less for Chinese products. Then it could — theoretically — pass those savings along to shoppers like me.
There is a downside, though.
Although imports benefit from the strong dollar, exports tend to struggle. The trade deficit worsens, and American companies that do a lot of business in foreign countries often take an earnings hit. As a result, firms like Tesla — which gets about a quarter of all its sales from China — might shift their strategies. They could eventually opt to produce fewer products stateside and cause a ripple effect for the Americans who work in those factories.
But I may be getting ahead of myself. Barbera tells me that, so far, the dollar's uptick isn't too unusual.
However, if the Fed continues to aggressively tighten rates over the next six months, the U.S. could see a dramatic appreciation reminiscent of what happened a couple of times during the ‘80s and ‘90s, he says. Which could have serious economic repercussions.
“I’m not saying that will happen, but we’re in a position right now where it’s worth contemplating," he adds.
The bottom line
The "strength of the dollar" refers to its value relative to other currencies. The dollar is currently appreciating because of the Fed’s attempt to curb inflation, making imports cheap and exports costly.
Big corporations that rely on sales in foreign countries for a lot of revenue may be worried, but a strong dollar is good for American consumers shopping and taking trips abroad.