What does the dollar really affect?

No one involved in financial markets or economic analysis would dispute the importance of the dollar. It is simply one of those givens — important because everyone says it is important. If we have learned anything since the birth of the present system in the early 70s, it is that exchange rates affect everything else in the economy.

It shows nine macroeconomic variables affected by exchange rates and the impact of improper valuation. We can move down the list in short order; a caveat of “all else held equal” applies to all items.

If a currency is overvalued, it is equivalent to saying there are too few units of it relative to demand, and each unit therefore acts as a stronger claim on external goods and services. This is why a too strong currency was posited to lead toward a current account deficit and a capital account surplus, a situation that has prevailed in the U.S. for more than three decades.

Exports denominated in an overvalued currency are relatively expensive, but the cost of plants and equipment in the importer’s market is lower. This favors direct investment, which the Japanese automobile industry has done for years in the U.S. The cost of labor in that currency rises, which favors minimizing labor content except for certain highly skilled workers who can add value. A cheap currency, such as the Mexican peso, rewards unskilled labor in that country.

If holders of an overvalued currency sense its overvaluation, they will exchange it for goods and services and favor consuming over saving. Also, if every unit of that currency is a greater claim on goods and services, downward pressure on prices and presumably interest rates will result. Economics does not operate in a political vacuum. The downward pressure on prices and the shift of labor preference from unskilled to skilled inevitably leads to calls for a looser monetary policy. Lower inflation always rewards creditors relative to debtors, a delicate balance in any democracy: All societies have more debtors than creditors, but only in a democracy can debtors win an election.