Understand the Indirect Effects of Exchange Rates

The average person perceives the value of currency as fairly stable from day to day. The price of a cup of coffee every morning is $1.50, the fixed-interest car payment and mortgage are the same every month, and for a salaried worker, even the paychecks are identical. The fact that the value of currency is constantly fluctuating in relation to other currencies only seems to matter for most people when planning a foreign trip or making an internet purchase from a foreign website. This limited view, however, is mistaken.

The indirect impact of exchange rates and their fluctuations extends much more broadly and deeper in ways that affect several of the most important aspects of our economic lives—like how long it takes to get a job, where we can afford to live, and when we can retire. Exchange rates have a tremendous influence on the economy both in the near term and over prolonged periods of time.

Key Takeaways

• Changes in exchange rates may not seem to affect most people in their everyday lives, but indirect effects are more widespread than many realize.
• When exchange rates change, the prices of imported goods will change in value, including domestic products that rely on imported parts and raw materials.
• Exchange rates also impact investment performance, interest rates, and inflation—and can even extend to influence the job market and real estate sector.

Exchange Rates and What You Pay for Goods

In this era of globalization, goods from other countries are as commonplace, or sometimes even more commonplace, than those produced domestically. Exchange rates have a significant impact on the prices you pay for imported products. A weaker domestic currency means that the price you pay for foreign goods will generally rise significantly. As a corollary, a stronger domestic currency may reduce the prices of foreign goods to some extent. 

Let’s illustrate the impact of a weaker domestic currency on product prices with an example. Assume that the Canadian dollar (C$) declines by 10% against the U.S. dollar (US$) over the period of a year, from a rate of 90 U.S. cents per C$ (US$1 = C$ 1.1110) to 81 U.S. cents (US$1 = C$1.2350). What would be the price change in Canadian supermarkets for a pound of California almonds that are available in the U.S. for US$7? All else being equal (assuming no other costs and only taking exchange rates into account), the price of California almonds in Canada would increase from about C$7.78 (i.e., approx. US$7 x 1.1110) to C$8.65 (US$7 x 1.2350) per pound.

As another example, let’s look at the effect of currencies and prices when more than one country is involved. For example, say that the euro tumbled more than 20% against the U.S. dollar over a one-year period. During the same time, say the Canadian dollar had also declined, but only by 10% against the U.S. dollar, by comparison. As a result, the Canadian dollar had actually appreciated about 15% against the euro over that year (e.g., from C$1 = EUR 0.65 to C$1 = 0.75), resulting in Canadians paying somewhat lower prices for European products such as wine and cheese.

The change in the price of imported products depends on how the currencies of the exporting nations (i.e., those from where these products have been sourced) have fared against the domestic currency. Following the 2008-09 financial crisis and ensuing recession, the U.S. dollar reigned supreme against most major currencies, which resulted in American consumers paying relatively lower prices for imports such as German automobiles or Japanese electronics.

Exchange Rates and Inflation and Interest Rates

 A weak domestic currency can push up the inflation rate in a nation that is a big importer, because of higher prices for foreign products. This may induce the central bank to raise interest rates to counter inflation, as well as to support the currency and prevent it from plunging sharply. Conversely, a strong currency depresses inflation and exerts a drag on the economy that is tantamount to tight monetary policy. In response, a nation’s central bank may move to keep interest rates low or reduce them further so as to preclude the domestic currency from getting too strong.

The exchange rate thus has an indirect impact on the interest rate you pay on your mortgage or car loan or the interest you receive on the money in your savings or money market account.

Exchange Rates and the Job Market

 A weak domestic currency spurs economic growth by boosting exports and making imports more expensive (forcing consumers to buy domestic goods). Faster economic growth usually translates into better employment prospects. A strong domestic currency can have the opposite effect, as it slows economic growth and curtails employment prospects.

Exchange Rates and Investments

Exchange rate fluctuations can have a substantial impact on your investment portfolio, even if you only hold domestic investments. For example, the strong dollar generally dampens global demand for commodities as they are priced in dollars. This lower demand can affect earnings and valuations for domestic commodity producers, although part of the negative impact would be mitigated by the weaker local currency.

A strong currency can also have an effect on sales and profits earned overseas; in recent years, numerous U.S. multinationals attributed a hit to the top-line and bottom-line due to a stronger dollar. Of course, the effect of exchange rates on portfolio returns is well known. Investing in securities that are denominated in an appreciating currency can boost total returns, while investing in securities denominated in a depreciating currency can trim total returns. For instance, say that European stock indices reach record highs while the dollar is strengthening quite aggressively against the euro. American investors who had invested in those European-listed shares could actually see their real returns reduced substantially by the unfavorable exchange rate.

Exchange Rates and Real Estate

A weak or undervalued domestic currency can be like having an open-ended Black Friday sale and what is marked down is every single good, service, and asset in the country. The trick is, only buyers who can pay in the stronger foreign currency get the sale price. This attracts foreign tourists, which can be good for the economy. However, it also attracts foreign buyers looking to scoop up cheap assets and outbidding domestic buyers for them.

Foreign buyers have pushed up housing prices in nations with a weak currency. Imagine you are house hunting and suddenly you are bidding against people who are getting, say, an automatic 30 percent discount on the asking price. Even if you are not house hunting, high housing prices and low supply affect rent as well. In the past decade, local demand for housing has also been very robust in numerous nations, as their central banks held interest rates at record lows in a bid to stimulate their economies. This also had the effect of pushing their currencies to multiyear lows, raising fears of a global currency war.

The Bottom Line

Just like an iceberg, the major impact of exchange rates fluctuations lies largely beneath the surface. The indirect effect of currency fluctuations dwarfs the direct effect because of the huge influence it exerts on the economy in both the near term and long term. The indirect effect of exchange rates extends to the prices you pay at the supermarket, the interest rates on your loans and savings, the returns on your investment portfolio, your job prospects, and possibly even on housing prices in your area.

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