The New Zealand dollar is trading above 80 US cents again, which is great news for consumers but has some commentators worried.     A higher dollar lowers returns to exporters and makes borrowing to spend money on imports more attractive.   But advocating for a lower exchange rate is akin to advocating that wages should be lower, which is a brave position to take.

Let’s take a closer look at the relationship between wages and the exchange rate.   Unless you are a business owner who exports, changes in the exchange rate won’t directly affect the amount you get paid.   But as a wage-earner the higher New Zealand dollar means your existing income will go further in the global marketplace.

Just over two years ago the New Zealand dollar was trading at close to 50 US cents at the bottom of a cycle.   If the exchange rate had not risen again over the last two years, 91 octane petrol would be around $3.00/L by now.

And it’s not just imports which would be more expensive.  Goods and services produced domestically would also rise in price, because input costs would be higher and most domestic goods either compete with imports or are traded internationally.

Milk prices have been a favourite whipping boy of the median recent months.   But if the exchange rate was to suddenly fall to 50 US cents again we would likely pay at least $1 more for a two litre bottle of milk than we do at present.   After all, why would farmers want to sell to New Zealand consumers at the current price if they could get a better price overseas?

So we have established that a higher exchange rate is good for you as a consumer, as your income will go further.   But where does this extra income come from, and who decides how much we can buy with the mighty New Zealand dollar?

It shouldn’t come as a shock to learn that the value of a currency is decided by supply and demand.   New Zealand’s freely floating currency makes this process transparent, as traders are free to buy and sell our dollar and prices move accordingly.

The recovery in the New Zealand economy has been largely underwhelming over the last year.   But the one bright spot has been the massive run-up in the price we receive for our exports.   The ANZ Commodity Price Index tells us that weighted average export prices rose more than 80% over the last couple of years.   However, a rising exchange rate over that period means New Zealand dollar prices (what the exporters actually receive) rose 20%.

It would be easy for exporters to feel hard done by.   Adding insult to injury is that fact that the prices of some exports, such as many manufactured goods, have fallen in New Zealand dollar terms.   But on the whole the economy is still much better off.

So while a higher exchange rate has boosted consumer’s buying power, money hasn’t been created out of thin air.   Some of the extra income farmers are enjoying has ended up in your back pocket as a consumer.

When farmers sell their milk, meat, or produce overseas they have to buy New Zealand dollars in order to convert their international income back into local currency.   Thus the jump in export prices and strong export volumes has increased demand for New Zealand dollars from exporters, putting upward pressure on the value of our dollar.

When we buy our flat screen TV’s, cars, and other imported goods, we sell New Zealand dollars.   Thus as consumption of imports increases it puts downward pressure on the value of the New Zealand dollar.

These two opposing forces, along with investment flows between countries, help form the basis of the foreign exchange market.   A lot of trading volume is speculative, but this can actually lead to a more efficient market because if prices get out of line with fundamentals then errant traders will be punished when prices correct.   Although there are evidence bubbles can occur in exchange rate markets, it is hard to argue we currently have a bubble when export prices are so buoyant.

If an economy becomes tipped too much in favour of imports, its exchange rate would tend to fall.   But in New Zealand’s case, the massive increase in the price of the things we sell overseas has predictably led to a large appreciation in the value of our dollar making the consumer better-off.     It is only logical that the exchange rate and therefore your buying power should be at the current high level while exporters are enjoying such good returns.