The pandemic is over, and you are about to go on holiday abroad for the first time in a while. Destination, the luscious white sandy beaches of Florida Keys. Are you excited? I’m sure you are!
That excitement however has the capacity to increase or be dampened when you go to exchange your money.
Yet, the value of the dollar isn’t only tied to your holiday plans. 61% of all foreign bank reserves and almost 40% of the world’s debt is in those slender green bills, meaning that when it fluctuates, it doesn’t just affect those in the USA.
So what exactly causes the value of the dollar to rise or fall?
Let us break it down for you in our simple guide.
The Value of the Dollar and Inflation
We’ve all noticed, (and groaned) when the price of something that we usually buy goes up. This is inflation, a tale as old as time and when you hear about it increasing in the US, know that it will affect the value of the dollar.
Inflation happens when there is more money in circulation than the goods, services, and commodities available to buy. In simple terms, too much demand and not enough supply.
It is accepted that a slight rise in inflation between 1-3% annually is good for an economy, demonstrating economic growth. But when it happens either unexpectedly or when governments print a lot of extra money to encourage spending, it greatly devalues the currency.
So who decides on the rate of inflation in the US? The government?
Surprisingly not. To ensure impartiality, the rate of inflation is controlled by the federal reserve who is separate from the government. They try their best to control the rate of inflation in the US to avoid drastic changes, closely monitoring supply and demand among other things.
No one has enough money. That includes you, me, and even countries! This reality means that money is constantly being borrowed around the globe, usually from and by banks.
With this in mind, it is understandable that a contributing factor to the value of the dollar is the interest rate set by the Federal Open Market Committee (FOMC). The rate set by them is used by banks around the USA to determine what rate they will set for their products and services.
What effect can this have on the economy and by extension the value of the dollar?
These can be seen in the US and internationally.
Imagine you want to take out a mortgage to buy a house. With a high rate of interest, you will be reluctant to do so knowing that you would have to pay an amount that is unsustainable for you.
With a high-interest rate, the flow of money from consumer to business goes down, demand for houses, services, and other commodities goes down too and economical growth slows. But with less money flying around, the value of the dollar goes up due to international market interests. Confused?
Well if you are, remember that we said that money is constantly borrowed and lent.
As with any investment, the investment banks managing these funds are looking for a return on their investment. Therefore, if you are a bank that has money in Spain but the interest rate is higher in the USA, you will be better off putting your money into the US and reaping the benefits.
Keep Your House in Order
Imagine that you wanted to leave your money in a bank and you need to decide between two.
One has been open for years, has a good reputation, stable management and the interest rate is high for those who save there. The other one is badly run, has been hit by scandal and you are unsure whether it will be open within the next year.
Seems like a no-brainer, right?
The value of money all comes down to perspective. If the issuing country is seen to be responsible and most importantly stable, this will only have a positive effect on the value of its currency.
An active economy producing goods that are in demand internationally, high levels of employment, and a stable political climate are the magic formula that every country dreams of.
Sustained economic growth and stability in all these areas have been America’s strong suit over the years, meaning the value of the dollar has always been banked on in international trade. This can mean some foreign exchange risk, but on the whole, it has seemed logical for investors to buy dollars.
Forex Traders Keep It Moving
We have gone through three main factors that can make the value of the dollar appreciate or depreciate, but the last one allows for more of a human element.
Forex traders are people who trade on the value of the currency. There are fine margins on what can cause a currency to shoot up or come crashing down, and a forex trader’s job is to take into account all the factors that we have discussed and more. Using this information they speculate on which currency is most profitable and make assessments on which currency to buy and sell.
When all around you is crumbling, it is only natural that you look somewhere for stability.
In the world of forex trading, that currency is the dollar. In 2019, 88% of trade was done with the dollar due to its safe-haven status. We expect this to continue with Morgan Stanley choosing it as its number 1 currency even after experiencing a worldwide pandemic.
Dollar, Dollar Bill Y’all
So how is the value of the dollar determined? As we have seen there isn’t a simple answer. Many different cogs turn to make it rise or fall, however, none of them is a guarantee of it happening.
Hopefully learning a little bit about why it happens can help ease the pain, or enhance the joy, you experience the next time you are on foreign soil!
If you enjoyed this post be sure to check out our other informative financial posts.