The US dollar. How valuable is it?

Contents
Introduction
Chapter 1. The History of Dollar
Chapter 2. What makes the currency less or more valuable?
Chapter 3. How the Value of Dollar Affects the US Economy
Conclusion
References

The US dollar. How valuable is it?

Consistent policies. If investors feel that things will largely stay the same, they’ll flock to the dollar because it’s a safe bet. This increases demand and thus, the value of the dollar. Remember, unlike many other investment vehicles, forex is hurt by volatility. This is especially true with regard to financial policy: if investors believe US policy is on the right track, they’ll want to put money in dollar-denominated investments. Conversely, investors can lose faith in an economy that can change with new policies, so they’ll see the dollar as less of a safe bet.
Tax cuts for consumers. Tax cuts for consumers’ fuel spending, which can improve the economy of our country as well as others, like China. This can be good for the dollar as long as it does not deepen the trade deficit or ourbudget deficit. On the other hand, increases in taxes discourage personal spending, but they help with government spending and debt. This can slow the economy, but at the same time lessen our deficits.
Other countries. Political impact on the dollar does not originate entirely from the US; it can come from all over the world. Trade, conflict, consumption, and other issues can affect the dollar from outside our country. When other countries are in a state of conflict, their respective currencies may be perceived as unstable. In this case, investors may flock to the dollar because it is considered a safer bet. On the other hand, if other countries are consistent in their policy-making as well as politically and economically stable, the dollar may weaken because investors have more confidence in these alternative currencies. They’ll see them as less risky and diversify into non-dollar denominated assets.
A change in foreign reserves. The USD benefits strongly from being the world’s reserve currency. Most central banks hold more dollars than any other currency, but the dollar faces problems when they decide to diversify their currency investments. This could mean that they sell dollars, or simply just stop buying more. This is especially damaging when a large purchaser like China decides to stop adding to its foreign reserves.
Acceptance of oil in dollars. As long as the majority of world oil contracts are settled in USD, other countries have to use the currency. This increases demand for the dollar and therefore, its value. Additionally, most oil exporters hold a significant portion of their oil proceeds in dollars.
Social Security. It’s apparent to Americans and foreigners alike that Social Security is a sinking ship that will only get worse with time. Clearly, this causes investors to lose faith in the US money management system, but when the US works to reform the program, some of this confidence is restored and the dollar can benefit.
Demand for dollars. This factor can be tied to most others, but it can function on its own as well. For example, "if French investors saw an opportunity in the U.S., they might be willing to pay more francs in order to get dollars to invest in the U.S." More francs per dollar means the dollar’s value has risen.
Increase in money supply. With every new dollar printed, each one is valued less than before. The more dollars there are in circulation, the less the currency is valued because the supply has been increased. In practice, this usually causes inflation, which directly eats into the value of the dollar. While this would seem difficult to measure, the Federal Reserve periodically publishes M2 and M3 data reports on the US money supply.
Interest rates. Just like consumers might shop around for the highest-yielding savings account, foreign investors look for the best deal in currencies. Here’s how interest rates affect the dollar’s value. Higher interest rates mean more profit for investors, so a US rate hike will generally strengthen the dollar. In the long-term, however, the law of interest rate parity dictates that currency valuations and interest rates should move in opposite directions. The opposite also holds true. If the Fed lowers interest rates, investors might drop the dollar in the short-term because there’s not enough profit in it.
American consumers. American consumers have the most at stake in the dollar’s value. A fall in the dollar makes consumers’ money worth comparatively less, putting a squeeze on the budgets of the Average Joe. Yet there are several things that consumers do that serve to drive down the buying power the dollar. Here’s how Americans do it.
Consumer savings. Americans aren’t big on savings. In fact, most families have a negative net worth. While this has contributed to a strong economy in the short-term, it means the US is ill equipped to support the economy in the long-term. Additionally, negative domestic savings drives us to import foreign savings, which harms the dollar.
Gas prices. Rising gas prices leave consumers with less money to spend elsewhere, or worse, drive them to borrow money to keep up their standard of living.
Industry and economic indicators. American industry both affects and reacts to the value of the dollar. When the dollar falls, our goods become cheaper and more attractive. However, when we have a strong dollar, our industries have to compete harder against cheaper foreign labor and goods.
Outsourcing creates a trade deficit and causes US employment to suffer, resulting in a fall of the dollar. However, outsourcing also makes US companies more profitable and more attractive targets for foreign investment.
Entrepreneurship creates attractive investment opportunities for foreign investors, supporting a stronger dollar.
Employment growth. Like manufacturing growth, employment growth is a good indicator for the overall health of the economy. Positive employment growth will attract more investors and create a stronger dollar. Unnaturally high unemployment causes the dollar to drop because the government loses tax revenue that could help with the deficit. It also takes consumer purchasing power away, which causes the economy to suffer.
Wage data. Higher or lower wages can either attract or scare off investors, creating a fluctuation in the dollar’s value.
US capital markets. US stocks, bonds, and other investments can be appealing no matter where you are in the world. The performance of US capital markets can either attract or reduce foreign investment, which directly affects the dollar.
Economy. The current performance of the US economy is synonymous with the financial health of our nation. It signals to investors our ability to pay back debts as well as the profit level they may earn. In general, a strong economy will raise confidence, assuring foreign investors that they’ll earn a good profit on a stable investment. Economic growth is even better, attracting investors who hope that their investment will grow, too. A boom in the economy can cause an investment rush that results in a temporary overvalue of the market. This can lead to a dollar loss when it corrects itself in a slow of the economy.
Weather affects the agricultural industry, energy consumption, and local economies. Any change, for better or for worse, can create a ripple affect that impacts the economy as a whole and causes the dollar to fluctuate.
Inflation directly eats into the value of the dollar. The law of purchasing power parity (PPP) holds that a nation’s currency and its general price levels should move in opposite directions. A slow in inflation of foreign goods keeps prices of those goods steady, allowing American consumers to purchase the same amount or more of the same goods. This does not help to close the trade deficit and can weaken the dollar.
Of course, any news about possible inflation of the dollar or foreign goods can cause the foreign exchange market to react preemptively and fluctuate the dollar one way or another.
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Chapter 3. How the Value of Dollar Affects the US Economy
Dollar is losing value over the long-term. The dollar's value can be measured by exchange rates, Treasury notes and the amount of dollars held by foreign countries. These three measurements usually are in sync with each other. No matter how you measure it, the dollar is losing value over the long-term. Here's why. The U.S. debt is over $14 trillion. Foreign holders of this debt are concerned that the U.S. will let the dollar value decline so the relative value of its debt is less.
The large debt could force the U.S. to raise taxes to pay it off, which would slow economic growth. As more countries join or trade with the European Union, demand for the euro increases. Foreign investors are diversifying their portfolios with more non-dollar denominated assets. As the dollar loses value, investors are less likely to hold assets in dollars as they wait for the decline to stop.
The U.S. dollar is most easily measured by its exchange rate, which compares its value to other currencies. Currency exchange rates allow you to determine how much of one currency you can exchange for another. Exchange rates change every day because currencies are traded on the foreign exchange market, known as forex. A currency's forex value depends on a lot of factors, including Central Bank interest rates, the country's debt levels, and the strength of its economy. Most countries allow their currencies to be determined by the forex market. This is known as a flexible exchange rate.
Dollar Value Compared to Euro:
2011 - The dollar's value against the euro fell 10%, and then regained ground. As of October 7, 2011, the euro was worth $1.35.
2010 - The EU debt crisis strengthened the dollar. By year end, the euro was only worth $1.32.
2009 - The dollar fell 20% thanks to debt fears. By December, the euro was worth $1.43.
2008 - The dollar strengthened 22% as businesses hoarded dollars during the credit crisis. By year end, the euro was worth $1.39.
2002-2007 - The dollar fell 40% as the U.S. debt grew 60%. In 2002, a euro was worth $.87 vs $1.44 by December 2007. (Source: Federal Reserve Bank, Exchange Rates)
The dollar is held by foreign governments who have an excess of dollars, which they hold in foreign currency reserves. The excess happens when countries, such as Japan and China, export more than they import. As the dollar declines, the value of their reserves also decline. As a result, they are less willing to hold dollars in reserve. They diversify into other currencies, such as the euro or even the Chinese Yuan. This reduces demand for the dollar, putting further downward pressure on its value. Some experts fear that Japan's 2011 earthquake will force it to sell its dollar reserves, which it holds as Treasuries, to pay for reconstruction from the disaster.
When the dollar declines, it makes U.S. produced goods cheaper and more competitive when compared to foreign produced goods. This helps increase U.S. exports, boosting economic growth. However, it also leads to higher oil prices in the summer, since oil is priced in dollars. Whenever the dollar declines, oil producing countries raise the price of oil to maintain profit margins in their local currency.
The growing U.S. debt weighs in the back of the minds of foreign investors. That's why they may continue to gradually move out of dollar-denominated investments - slowly, so they don't diminish the value of their existing holdings. The best protection for an individual investor is a well-diversified portfolio that includes foreign mutual funds.
Reduce the US current account deficit. It should also reduce the Chinese current account surplus. This some may help reduce some of the economic imbalances in the global economy.
Countries which export a lot to the US may witness a fall in economic growth. The Chinese government is worrying about this situation. It is one reason why they are trying to prevent the Yuan appreciating too much.
The impact of devaluation depends upon the elasticity of demand for exports and imports. If demand is relatively inelastic then an increase in the price of imports may not reduce the value very much. If this is the case, the impact of a devaluing dollar will be limited.