Would increased cost inflation in the United States relative to its major trading partners likely increase or decrease the value of the U.S. dollar? Why?

Answer:

U.S. foreign trade and global economic policies have changed direction dramatically during the more than two centuries that the United States has been a country. In the early days of the nation's history, government and business mostly concentrated on developing the domestic economy irrespective of what went on abroad. But since the Great Depression of the 1930s and World War II, the country generally has sought to reduce trade barriers and coordinate the world economic system. This commitment to free trade has both economic and political roots; the United States increasingly has come to see open trade as a means not only of advancing its own economic interests but also as a key to building peaceful relations among nations.
The United States dominated many export markets for much of the postwar period -- a result of its inherent economic strengths, the fact that its industrial machine was untouched by war, and American advances in technology and manufacturing techniques. By the 1970s, though, the gap between the United States' and other countries' export competitiveness was narrowing. What's more, oil price shocks, worldwide recession, and increases in the foreign exchange value of the dollar all combined during the 1970s to hurt the U.S. trade balance. U.S. trade deficits grew larger still in the 1980s and 1990s as the American appetite for foreign goods consistently outstripped demand for American goods in other countries. This reflected both the tendency of Americans to consume more and save less than people in Europe and Japan and the fact that the American economy was growing much faster during this period than Europe or economically troubled Japan.
Mounting trade deficits reduced political support in the U.S. Congress for trade liberalization in the 1980s and 1990s. Lawmakers considered a wide range of protectionist proposals during these years, many of them from American industries that faced increasingly effective competition from other countries. Congress also grew reluctant to give the president a free hand to negotiate new trade liberalization agreements with other countries. On top of that, the end of the Cold War saw Americans impose a number of trade sanctions against nations that it believed were violating acceptable norms of behavior concerning human rights, terrorism, narcotics trafficking, and the development of weapons of mass destruction.

Despite these setbacks to free trade, the United States continued to advance trade liberalization in international negotiations in the 1990s, ratifying a North American Free Trade Agreement (NAFTA), completing the so-called Uruguay Round of multilateral trade negotiations, and joining in multilateral agreements that established international rules for protecting intellectual property and for trade in financial and basic telecommunications services.
     Still, at the end of the 1990s, the future direction of U.S. trade policy was uncertain. Officially, the nation remained committed to free trade as it pursued a new round of multilateral trade negotiations; worked to develop regional trade liberalization agreements involving Europe, Latin America, and Asia; and sought to resolve bilateral trade disputes with various other nations. But political support for such policies appeared questionable. That did not mean, however, that the United States was about to withdraw from the global economy. Several financial crises, especially one that rocked Asia in the late 1990s, demonstrated the increased interdependence of global financial markets. As the United States and other nations worked to develop tools for addressing or preventing such crises, they found themselves looking at reform ideas that would require increased international coordination and cooperation in the years ahead.

when there is increased cost inflation , the currency would lose value. which means inflation devalues the United States dollar. The more money in the economy, the less value it holds.The exchange rate with other currencies would then reflect the decrease in value. For example, if we look at the US$ vs. the Euro, from the current $1.30 per Euro, the dollar exchange rate should move to $1.43 per Euro (using a very simplified assumption of a 10% inflation in the US and no inflation in Europe, and the net value of the imports and exports are maintained). This also means that the exchange rate of Euros per US$ would decline from 0.77 Euro per US$, to about 0.70 Euros per US$, making it easier for European producers to export their products into the US, For the US producers, the decrease in the value of the UD$ would mean that they would have to raise their European prices to maintain the same level of profitability, making it more difficult to export. The US producers would then have an increased incentive to sell domestically, thereby inflation in the US should hopefully be reduced. The real world is somewhat more complicated. The complicating factors would include:

i. Many products are qouted in US$, The prime example is crude oil. Just about ALL the crude oil contracts have been in US$. So when the US$ is devalued, the price of crude will merely increase proportionately.
Since the short term demand for petroleum products is relatively inelastic, the increase price of crude would increase inflationary pressures.

ii. Many other currencies are somewhat pegged to the US$. Therefore, the loss of value in the US$ may not actually occur because other countries would maintain the same relative exchange rate against the US$.
So the Chinese renminbi (also called the yuan) which is about 6.8 yuan per US$, would probably not change much. The Chinese monetary authorities would have to buy more US$ to maintain this informal 'peg'.

The, net outcome is somewhat indeterminate. Classical Economic Theory would say that with the increased imports of goods and the decrease exports, the supplies in the US would therefore increase. So with increase supplies, the prices should drop, thereby curtailing the inflationary pressures. In actuality, much of the benefits of the loss in value in the US$, may not be fully realized because of the factors outlined above. It would still be the responsibility of the US Federal Reserve to tighten the money supply by raising interest rates through the discount window or open market operations, or increasing reserve requirements. This should lower demand and therefore, decrease the inflationary pressures.