Factors other than domestic demand affect how much the American dollar is worth. Treasury notes, foreign demand for U.S. currency, foreign exchange rates and the stability of the euro are all factors that play significant roles in the value of the U.S. dollar. Even when considering these influences, supply and demand is what determines the value of the dollar in the end.
Supply and Demand
Supply and demand affects the value of the U.S. dollar in both the domestic and foreign economies. The dollar increases in value when U.S. currency is in greater demand and loses value when fewer people want the currency available. For example, when the United States imports goods from foreign countries, the value of the dollar decreases because the United States must buy foreign currency to pay for its imports. On the other hand, a strong U.S. export market increases the value of the dollar as exchanging foreign currency for U.S. dollars increases the demand. Similar to how international trade works, Americans investing in foreign companies affect the availability and value of the U.S. dollar. Likewise, foreign investors buying U.S. securities or putting money into American companies affect currency values.
U.S. Treasury Notes
Treasury securities serve as collateral for the amount of banknotes, or paper money, that the Federal Reserve Bank puts into circulation. As a result, the dollar’s value is determined by how much investors are willing to pay for Treasury notes and bonds. When the demand for notes is high, investors pay more than face value. Investors pay less than face value when the demand is low, but they receive higher investment earnings. Since it takes higher interest rates to pay out higher yields, higher interest rates mean that less money is available. However, the potential for earning higher profits attracts foreign investors. Interest rates drop lower once more cash becomes available.
Foreign Exchange Rates
Exchange rates provide another measure of the dollar’s value. An exchange rate is the value of the U.S. dollar when compared to the value of foreign currencies. Rates change daily depending on the strength of a nation’s economy, how much debt it owes and the interest rates set by a country’s central bank, which in the United States is the Federal Reserve System. For example, the value of the U.S. dollar weakens as the nation’s debt continues to grow and foreign investors shy away from making U.S. currency investments.
Like other floating currencies, the exchange rate between the U.S. dollar and the euro — the currency of 17 of the European Union's 27 member nations — is determined by supply and demand. In recent years, the value of the U.S. dollar against the euro has fluctuated up and down, with U.S. interest rates and budget deficits often cited as the cause when the dollar loses value. The trade deficit is another contributing factor. When the U.S. dollar is worth less than the euro, Americans must pay more for imported goods. A reverse concern is that if the euro drops significantly in value, European banks may be unable to repay American creditors, which could do more damage to an already ailing U.S. economy.
- Federal Reserve: Currency and Coin Services
- Federal Reserve Bank Services: Coin and Currency Frequently Asked Questions
- The American: How to Think About the U.S. Dollar
- Forbes.com: Supply and Demand in Currency Markets
- Graziadio Business Review: the Dollar vs. the Euro
- Infotrak: How Do Interest Rates Affect the Economy
- CNN: Why the Euro Crisis Is an American Problem
- Digital Vision./Photodisc/Getty Images