The sharp fall of the dollar relative to other currencies, most notably the euro, over the last several years has many in the U.S. worried. At its peak in 2000, one dollar bought you more than one euro, but now it takes  more than $1.50 to buy one euro. Secretary of the Treasury Henry Paulson and the Fed Chairman Ben Bernanke, among others, recently have voiced concerns about the strength of the dollar. Its weakness  has been blamed for high energy prices and high commodity prices in general.

Surprisingly, the weak dollar brings some benefits. Economic theory and common sense say that when the dollar gets cheaper, U.S. products also become cheaper relative to those made in other countries and U.S. firms become more competitive in international markets. Exports should increase.  In addition, U.S. imports should fall  as the weaker dollar leads Americans to buy fewer foreign goods and services. Because of this net exports (exports minus imports) should increase.  Since net exports are one of the components of the gross domestic product, an increase in net exports should contribute to the GDP growth.

This is exactly what we see happening in the U.S. right now. In April, the dollar has reached the lowest point against the euro since the euro’s introduction in 1999. In March, the index that measures the foreign exchange value of the dollar relative to currencies of major U.S. trading partners reached the lowest point since 1995. Simultaneously, in the second quarter of 2008, U.S. net exports increased substantially. This increase in net exports was the strongest contributor to the growth of real GDP in the second quarter of 2008, as reported by AIER in a recent commentary.

This is not just a one-time occurrence. The growth of net exports has been accelerating since 2006 while the dollar has been falling against the currencies of U.S. trading partners.  The chart below shows the index of the foreign exchange value of the dollar. The index, which is reported by the Federal Reserve,  is a weighted average of the values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. An increase in this index indicates appreciation of the dollar. Economic theory suggests that we should see an increase in the growth of net exports when the dollar is weakening, which is exactly what started to happen in 2006.

The growth rate of net exports on the chart is more volatile than changes in the exchange rate alone would suggest because additional factors (such as trade policies or economic growth in the U.S. and its trading partners) affect net exports.

As the dollar has weakened, net export growth has accelerated 

Moreover, there is a self-correcting mechanism built into the market. The value of a currency, as the value of any other product, essentially depends on the supply and demand for it. Increased demand for U.S.-made products leads to higher demand for dollars, which are required to buy those products. In addition, faster GDP growth created by higher net exports leads to higher income and higher spending within the U.S., which also leads to higher demand for dollars. Thus, eventually the demand for dollars would increase, leading to appreciation of the dollar unless there are sharp changes in supply. The dollar cannot keep falling forever.