Value and Disvalue of a Strong Currency

Posted: 29 Nov 2016

Date Written: November 25, 2016

Abstract

Depending on whether you are a political scientist or an economist, there are dichotomously different views on the utility of a strong currency. Specifically, political economy argues that a strong currency is the buttress of a strong country; on the other hand, micro and marcoeconomics put forward the view that a currency’s value ebbs and flows depending on market forces and economic fundamentals. But, what are the advantages and disadvantages of a strong currency? It depends on the structure of the economy, and the strength of its fundamentals relative to major trading partners. A weak currency, which is also an undervalued currency, is useful if the country relies heavily on exports to the world. These exports could be electronics, agricultural or services. Hence, given the argument that a country needs to export goods to earn income for the economy, would an undervalued currency be preferable over an overvalued (strong) one? The answer requires the examination of the other side of the equation: the role of imports to an economy. If the country is an open economy with the need to import raw materials or semi-finished products for final assembly, a strong or slightly overvalued currency would reduce the cost of imports and the final price of the exported product, making it more competitive in the international market. On the other hand, if the manufacturing process rely less on imports of components, a weak or undervalued currency would boost the export of the final product as it is cheaper after accounting for currency differentials. Hence, it is a trade-off between the relative balance of imports and exports that flow in and out of an economy that suggests a suitable price for a currency that would have, overall, a balanced effect on the economy: i.e., no significant advantage and disadvantage in either direction. The economic measure of this is terms of trade - the relative price of imports versus exports. Therefore, one may ask: how should the exchange rate be set? And on what timescale? Daily or monthly? Should the currency's price be based on a benchmark interest rate, bank reserve requirement, or on a basket of currencies of the major trading partners of a country? Or alternatively, could a currency’s exchange rate be set based on changes in terms of trade of a country against the major trading partners of an economy? Using data from the daily fluctuations of a currency in the foreign exchange markets, does the movement in price of the currency correlates with that of terms of trade, which provide some measure of economic fundamentals in pricing a currency; thereby, helping sort out the portion of a currency’s price underpinned by financial flows and sentiments in the market. On the other hand, is terms of trade a better reflector of the dynamic operation of an economy, and thus, tells a cogent tale of the monthly (not daily) fluctuations in exchange rate, where daily price differences in a currency get their information input from relative demand and supply of the currency in the markets? At the fundamental level, is it possible to calculate a theoretical value of a currency based on one measure: terms of trade, and what timescale is it good for; for example, on a monthly or quarterly basis? Economists who find the above ideas and questions useful may expand on them in their research.

Keywords: exchange rate, balance of payments, capital account, trade balance, trade deficits, currency trading

JEL Classification: E00, E01, E40, E50, E51, E43, E44, F10, F31, F32, F41

Suggested Citation

Ng, Wenfa, Value and Disvalue of a Strong Currency (November 25, 2016). Available at SSRN: https://ssrn.com/abstract=2875671

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