Lecture Notes: The Dollar Smile Theory and Its Global Impact

Overview of the Dollar Smile Theory

• The value of the dollar is at its highest since the early 2000s.
• Dollar Smile Theory: The dollar strengthens in two scenarios:
  1. Healthy U.S. Economy: Leads to economic growth (e.g., 2014).
  2. Global Economic Shocks: Leads to increased dollar demand (e.g., 2022).
• Weakens when the U.S. economy is declining compared to the world (e.g., 2008 Great Recession).

Current Context (2022)

• The dollar is reaching multi-decade highs.
• The Federal Reserve is increasing interest rates.
• Economic uncertainty and fears are prevalent.
• The increase is unexpected and rapid.

Global Impact of a Strong Dollar

• The dollar is a dominant global reserve currency.
  • Held by 149 countries, nearly $7 trillion.
  • Provides stability for investors.
• A strong dollar affects global trade and pricing:
  • Many goods priced in dollars, leading to inflation in other countries as their currencies weaken.
  • Emergence of a concept where a stronger dollar "exports" inflation to emerging markets.

Benefits and Drawbacks of a Strong Dollar

• Benefits for the U.S.:
  • Cheaper imports, leading to lower prices.
  • More affordable travel abroad for Americans.
• Drawbacks for the U.S.:
  • U.S. exports become more expensive for other countries.
  • Decreased sales for companies with significant international revenue (e.g., Microsoft, Salesforce, Coca-Cola).
  • S&P 500 companies generate 40% of revenue from outside the U.S.

Market Reactions and Future Outlook

• The strong dollar can lead to lower earnings and reduced import costs, curbing inflation.
  • Comparable to a rate hike by cooling economic activity.
• Future Expectations:
  • Dollar expected to stabilize as inflation cools, geopolitical uncertainty diminishes, and global economic growth resumes.
  • The dollar will likely "stop smiling" as the global economy stabilizes.