What determines the value of the dollar depends on a number factors within the economy that are dynamic, and constantly affect changes in the price. The best that one can do is to determine the dollar’s value at a point in time, and this can change from minute-to-minute within any time frame.
The type of currency that most of the world uses is known as fiat currency. This is a currency that is not actually backed by anything, and is left to float in the world currency markets letting supply and demand determine its price. Its value is determined against other world currencies in the form of currency pairs. These pairs are presented as a ratio with the value of one, the base currency determined in terms of the other, or the quote currency.
Example: The value of the dollar in relation to the Euro would be determined by the currency pair USD/EUR. At a certain time on July 12, 2010 the pair looked like this: USD/EUR =.7943. This indicates the value of a US dollar was .7943 in comparison to the value of the Euro currency. A newspaper on the previous day of July 11 listed the dollar’s value at .7909 Euro; this was probably the closing price for that trading day on the London Exchange.
Most governments do not leave their currencies to float completely free in the markets. They have adopted monetary systems that exert an influence on their currency’s price, and the prices of other currencies.Some methods governments use to keep a currency price stable, or fixed, are:
- 1. Buy and sell foreign currency, thereby dampening price increases or decreases.
- 2. Bonds may also be sold on the open market to decrease the money supply.
- 3. The currency reserve requirements of commercial banks may be raised or lowered.
Image Credit – History of Fiat Currency ( )
Foreign Currencies Exchange Markets
Foreign currency exchanges are a decentralized group of currency markets located throughout the world where currencies can be bought or sold to meet the demands of commerce and investment twenty four hours a day during the business week. The foreign currency exchange markets are located in the major financial centers of London, New York, Tokyo, Frankfurt, Zürich, Paris, Hong Kong, Singapore, and Sidney.
How Trade Can Determine the Price of the Dollar
When commerce is transacted internationally for goods, services, and transfers, a nation’s balance of trade and investment capital are affected which are represented by two accounts, the current account and the financial account.
A trade imbalance in the current account, known as a deficit, is caused by imports out-pacing exports. This means that more dollars are leaving the country, and that there is less demand for dollars outside of the country. This shrinks the available money supply causing an appreciation of the dollar, and a slowing down of the economy.
Exports out-pacing imports, turns the balance in the opposite direction, and is called a surplus. This is usually accompanied by an increase of economic activity that causes more dollars to flow into the country, as more nations are spending them to buy cheaper domestically produced goods. More dollars being circulated in the hands of the public means a decrease in the dollars value.
Please click on Page 2 to learn more on what determines the value of a dollar including investments and other factors.
How Investments Determine the Price of the Dollar
An increase, or decrease in a financial account is another factor that affects the value of the dollar. This involves the inflow and outflow of capital goods (investments) in the economy. This account exhibits deficits and surpluses, just like the current account.
The role of interest rates is a key factor in determining the value of a dollar. The demand for US bonds and other interest bearing instruments increases among foreign investors when the interest rates rise. This creates a demand for dollars to pay for these investments, and the price of the dollar increases accordingly.
Image Credit: Dollar-US (Wikimeda Commons)
There many other factors that help determine the value of the dollar that can range from foreign conflicts to the weather affecting crops. Some other fundamentals that are thought to affect the value of the dollar are:
- Growth rate of the economy
- Budget deficit and the national debt
- Strong foreign economies
- Gas prices
- Housing market
- Changing interest rates in other countries
The economic fundamentals previously discussed are applied to valuing the dollar in the long-run. Valuing the dollar in the short-run is considered quite difficult, and is believed by many to follow a random walk. That is, the likelihood of an increase in the value of the dollar is just as great as a decrease.
Tools that are used to try and predict where the dollar, and foreign exchange rates are going in short time periods are called technical indicators. They take many forms, and are very chart oriented, such as utilizing mathematical algorithms in their calculations, and visual renderings. Some popular ones are:
- Moving Average Convergence Divergence (MACD)
- Various kinds of moving averages
- Stochastic Oscillator
The value of the dollar is a constantly fluctuating value, and is believed to be affected by many economic fundamentals in the long-run. Some governments do try to keep their currency fixed by actively engaging in methods that affect the market prices in the short-run (less than a year).
Jeffrey A. Frankel, "Foreign Exchange," The Concise Encyclopedia of Economics, 2008, Library of Economics and Liberty, retrieved July 11, 2010 from the World Wide Wide Web: https://econlib.org/cgi-bin/printree.pl
undisclosed, "50 Factors that Affect the US Dollar," CurrencyTrading.net, 2007, retrieved July 11,2010 from the world Wide Web: www.currencytrading.net/…/50–factors-that-affect-the-value-of-the-us–dollar/
undisclosed,"US Money History," US Treasury Department, Bureau of Engraving and Printing, 2010, retrieved July 11, 2010 from the World wide Web: https://www.bep.treas.gov/uscurrency/history.html