Spotlight On Economics: Monetary Policy And Exchange Rates

By Robert Herren

Professor of Economics NDSU Agribusiness and Applied Economics Department

Because most agricultural markets are global, changes in a nation’s exchange rate will affect the profitability of many agricultural sectors.

For example, an appreciation of the U.S. dollar (stronger dollar) will increase the price of U.S. exports of currently produced agricultural goods. A depreciation of the U.S. dollar (weaker dollar) will decrease the price of U.S. exports in world markets.

Since the early 1970s, the U.S. has allowed it currency to float so that demand and supply in the foreign exchange market determines the dollar’s value. Each day, the foreign exchange market handles more than $5 trillion of transactions. More than 99 percent of these transactions involve buying and selling assets, mostly financial assets such as bonds and equities.

Risk is one factor that affects supply and demand in the foreign exchange market; most investors are risk-averse. Because U.S. Treasury Department securities are considered relatively safe, investors often increase their demand for Treasury securities during times of global economic and political turmoil, thereby causing the U.S. dollar to appreciate.

For example, during the fall and winter of 2014, the dollar became stronger after Russia invaded Ukraine, thereby sending investors (including many within Russia) scurrying to buy assets perceived to be safe. More recently, Brexit (Great Britain’s vote to leave the European Union) caused an influx of funds into U.S. financial assets, resulting in a stronger dollar relative to the British pound.

Monetary policy affects the expected return of domestic assets relative to the expected return of foreign assets by changing interest rates. When the Federal Reserve raises its target for the federal funds rate, thereby increasing short-term interest rates, domestic assets become more attractive to investors.

During 2015, investors perceived that improving labor markets ultimately would result in the Fed raising its target for the federal funds rate, thereby increasing demand for U.S. assets, particularly because the Bank of Japan and the European Central Bank were lowering interest rates.

After the Fed increased its target for the federal funds rate by .25 percent in December 2015, most investors thought the Fed would increase rates several more times in 2016. However, their perceptions changed in early 2016 because of instability and weakness in several foreign economies, including China. Some investors now sold U.S. assets and, on average, the dollar depreciated from late January until the Brexit vote.

In a fixed exchange rate system (such as a gold standard), the single goal of monetary policy is to maintain the fixed exchange rate. In the current floating exchange rate system, monetary policy focuses on domestic economic conditions. Congress has given the Fed a dual mandate: price stability and maximum employment.

To achieve these goals, the Fed may conduct monetary policy that results in fluctuations in the exchange rate. Thus, monetary policy contributes to the currency risk faced by agricultural producers and agribusinesses.

Source:ndsu.edu