Currencies rise and fall based upon the performance of the local economy and the sentiment of investors.

If a currency is in vogue, speculators can push its value to excessively high levels. If it goes out of fashion, it could fall to extremely low levels. Sharp movements in a currency can have significant consequences for the economy.

In the first part of our two-part piece about extreme movements in exchange rates, we explore the pros and cons of a strong currency. If the Aussie breaks its one-year high above 94 cents, it will be important to know how that move will affect the economy. For an export dependent country like Australia, a strong currency has more consequences than advantages.

Pros of a strong currency:

1. Stronger purchasing power»’

A strong currency increases the buying power of Australians while making foreign products less expensive. Australians are more confident and willing to spend when they feel richer and the cost of imported items is lower. So when the Aussie is strong, we tend to see the sale of imports rise in relation to exports.

Australians are also more willing to take international vacations when the local currency is strong, because it reduces the cost of foreign travel.

2. Potential earning surprises for importers

Australian companies with a large amount of expenses in foreign currencies can see their effective costs decrease with a strong currency. For example, if an Australian company owed a US company USD$1 million at an AUD/USD exchange rate of 80 cents, that USD$1 million would be worth AUD$1.25 million. At 95 cents, it would fall to AUD$1.05 million.

Similarly, a strong Aussie can increase international investments by Australian companies because it reduces the cost of cross-border mergers. At an 81 cent exchange rate, a US company worth USD$100 million would cost approximately AUD$123 million. At 95 cents, the same company would only cost about AUD$105 million — a savings of about 14 percent.

3. Lower inflation

A strong currency tends to reduce inflationary pressures, which could discourage a central bank from raising interest rates — usually positive for growth but negative for the currency.

Cons of a strong currency: »’

1. Hurts exporters

A strong currency increases the cost of Australian goods on the global market. Exporters start to complain when the currency becomes too strong because Australia is a major exporter. They fear its trade partners (namely China) will start to look for alternative import destinations. At that point, exporters would be faced with the tough decision of risking a fall in demand or reducing prices, which could drive down earnings and trade figures.

2. Reduces foreign profitability

A strong currency also negatively impacts Australian companies selling products abroad. Imagine that Foster’s sells a bottle of beer in the US for USD$5. At an AUD/USD exchange rate of 81 cents, Australia-based Foster’s would make AUD$6.17 per bottle. If the exchange rate went up to 97.2 cents, the revenue is only AUD$5.14.

Compounded by millions of Foster’s sold abroad, you can see how a strong Australian dollar can hurt Australian companies. A similar dynamic occurs in tourism — a strong currency encourages Australians to travel abroad while deterring foreigners from travelling to Australia.

3. Increases the cost of housing

The Australian housing market has also received a tremendous boost from foreign demand, but a strong currency could curtail housing by reducing the value and attractiveness of Australian real estate to foreign investors.

In Australia’s case, a strong currency generally has more consequences than benefits.

What do you think is the largest benefit of a strong currency? (Share your views below)