The value of a dollar is always changing in relation to other world currencies, such as the euro, the Japanese yen or the British pound. When the dollar falls in value, goods made in other countries become more expensive -- and much of what you buy is likely made in other countries. The most common causes of a falling dollar are interest rates, inflation, debt and trade.
Supply and Demand
As with most things, the value of a dollar is largely a product of supply and demand. When demand for dollars rises, compared with the demand for other currencies, the value of the dollar will rise, too. But when demand for other currencies rises in relation to demand for the dollar, the dollar will fall. So anything that reduces demand for dollars and increases demand for other currencies will drive the dollar down.
The interest rates in a country tell you how much return you can get for money invested there. When interest rates in the U.S. are high compared with rates in other countries, international investors convert money to dollars so they can invest in America, and the dollar rises. On the other hand, when U.S. rates are low, investors look elsewhere for opportunities. They trade their dollars for other currencies, and the dollar falls.
Prices tend to rise over time, but when prices are rising rapidly -- when there's high inflation -- the cash in your pocket loses value quickly. Something that cost $1 a week ago might be $1.02 today and $1.07 two weeks from now. When the buying power of dollars is shrinking because of high inflation, fewer people around the world want dollars. They swap their dollars for other currencies, and the dollar falls. In this kind of situation, the decline of the dollar is feeding on itself: The falling value reduces demand, which reduces value further. One thing that helps cushion the blow, though, is that inflation generally causes interest rates to rise, and that can provide some protection for the dollar.
High Government Debt
High government debt can weaken the dollar in a couple ways. For one thing, it means the government is putting more dollars into the economy (by spending) than it's taking out (in taxes). That can lead to inflation, since people have more dollars to spend on the same stuff. Also, the government has the ability to repay debt simply by printing more money, which would weaken the value of the dollars already in circulation. Even if the government doesn't deal with its debt this way, the fear that it might do so can be enough to make dollars less attractive compared with other currencies.
When you buy something made in Japan, at some point your dollars must be converted to yen. Likewise, when someone in France buys a U.S.-made product, her euros will get converted to dollars. When the U.S. is running a trade deficit -- that is, when Americans buy more stuff than they sell to the rest of the world -- there are more dollars being traded for foreign currencies. High demand for foreign currencies relative to demand for the dollar drives the dollar down. Partially offsetting the effects of debt and trade imbalances is the fact that the U.S. dollar is still considered safer and more reliable than most of the world's currencies. People worldwide believe that dollars hold value, so heavy demand for the dollar remains.
- Economics, 17th Edition; Paul A. Samuelson and William D. Nordhaus
- Microeconomics, Third Edition; Paul Krugman and Robin Wells
- Western Union Online FX: Understanding Why Currencies Fluctuate
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