Will the Falling Dollar Help or Hurt the U.S. Economy?
But is this development good for the U.S. economy? In the long run, the answer is an almost unqualified "yes", as it will reduce the imbalances of the U.S. economy. While I would have prefered a "tighter" fiscal and monetary policy to solve ths, a dollar depreciation is the second best solution (especially since as we shall see, it will likely force the Fed to pursue a less inflationary monetary policy).
With regards to the short term effects, however, the situation is much more complicated.
On the one hand, the falling dollar will of course increase U.S. exports and reduce the U.S. trade deficit (both because of increased exports and reduced imports). Something which in turn will of course boost economic growth.
Moreover, a falling dollar will increase the dollar value of foreign assets held by U.S. citizens and corporations (while leaving the dollar value of U.S. assets held by foreigners unchanged) and so help improve their balance sheets. Similarly, the falling dollar will increase the dollar value of the investment income of U.S. citizens and corporations from their foreign interest income/dividends/profits. This will help strengthen the U.S. factor income balance.
However, there will also be negative effects for America. This means mainly that the dollar decline will raise price inflation, which will have negative effects for two reasons. First because it will likely worsen America's terms of trade, and second because it will force the Fed to pursue a "tighter" monetary policy (while I again thinks this is good in the long run, the short-term effects of that is negative)
Why will it worsen America's terms of trade? Well, simply because currency movements have a much greater effect on commodity prices than the price of finished products and because America is a net importer of commodities.
For various reasons, the prices of finished products are relatively rigid. As you may have noted when you visit stores, prices usually don't fluctuate very much on a day to day basis or even on a monthly or even annual basis. And when they change, they usually don't change particularly much.
By contrast, prices on things traded on global financial markets, like commodities, fluctuate quite a bit, even within just a day and they often change dramatically from year to year.
While commodities are traded in dollars on global financial markets, it is still highly relevant what the euro or yen or pound or yuan price of a commodity is. Most
demand for commodities does after all come from outside the United States. So the commodity price in other currencies is the most relevant thing to consider. That means that a dollar decline will more or less automatically raise the dollar price of commodities, as the euro/yen/pound/yuan commodity price falls.
But as finished product prices are a lot more rigid, a dollar decline will more or less automatically produce a terms of trade gain for commodity exporters and a terms of trade loss for commodity importers like America.
Despite its abundant natural resources, America is a net importer of commodities, simply because America have such a large population and large economy, that its consumption of commodities exceed its production. Most of the net commodity imports is related to oil.
Because of this, the terms of trade of America (and other commodity importers) will worsen as a result of the dollar decline.
It should also be mentioned that as Brad Setser points out, the overall dollar decline haven't really been as dramatic as many people think on the basis of the decline in the value of the dollar against the euro and other european currencies, including the many countries that peg their currencies to the euro (meaning Denmark plus most Eastern European countries), but also for example the U.K. pound, the Swiss franc and the Swedish krona. But the fact is that most of America's trade is with non-European countries, limiting both the negative and positive effects of the dollar decline. The currencies of other important trading partners, most notably the Chinese yuan, the Japanese yen, the Canadian dollar and the Mexican peso have stayed basically unchanged or risen only slightly against the U.S. dollar.
Apart from the fact that this means that both the positive and negative effects of is the dollar decline is smaller than one would think by looking at the exchange rate of the dollar against European currencies, the relevance of this is that it will relatively boost the signifance of the for the American economy negative aspects of the dollar decline.
Why? Well, because while the effect on the trade balance and finished product prices is related to the trade weighted value of the dollar, the effect on commodity pruces is related to the global economic strength. And Europe have a much larger share of global GDP than its share of America's foreign trade. This will enhance the relative importance of the terms of trade decline for America, while reducing the relative importance of the positive effects on the trade balance (and the increase of the price of imported finished goods).
Because of the higher commodity prices, and also because the dollar decline will put a upward pressure even on finished import product prices (although that effect for aforementioned reasons is likely to be less dramatic.), consumer price inflation will all other things being equal be increased in America by the dollar decline.
Higher inflation will in turn make it a lot more difficult for the Fed to cut interest rates in response to the looming recession.
In conclusion, while the net effects on short-term economic growth prospects in America is likely to be small as there are opposing forces cancelling each other out to a large extent, it is at least ( probably more) as likely to be slightly negative than slightly positive.