What Makes the Dollar Weak?

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   Monetary Inflation

   • Official inflation figures, such as the Consumer Price Index (CPI) and Producer Price Index (PPI) are measures of price inflation. That is, they track changes in the price of goods. Long before there is price inflation however, there is monetary inflation. Throughout U.S. history, devaluation of the dollar has always been preceded by an increase in the money supply. In older days, this could literally mean the printing of additional paper currency. Today this is done through electronic transactions related to the Federal Reserve's open market operations. As with anything, when supply of dollars goes up, their value goes down.

   Fiscal Deficits

   • For most of its history, devaluations of the dollar have been driven by necessity. During periods of war, in particular, the risk of inflating the money supply is outweighed by the urgent need for military and defense spending. During the Great Depression, the dollar was devalued to help finance public works projects and social safety nets. When the government spends more money than it has, this fiscal deficit works in a way similar to the expansion of the money supply to lower the value of the currency. The instruments of government debt, U.S. Treasury bills, notes and bonds, are traded almost as if they were currency, and can literally be monetized if purchased or borrowed by the Federal Reserve, which pays for the privilege by introducing new dollars.

   Demand for Dollars

   • Demand for dollars worldwide also has an effect on the currency's value. For most demand for its currency is based on its exporting volume. Foreign companies and nations must purchase goods in the local currency, so high exporting volume creates a steady demand for the currency. For most of its history, the U.S. has been a net exporter. Relatively recently, though, in the last few decades, it has been a net importer, with a particularly negative trade balance in relation to China. Demand for dollars has been artificially inflated by its status as a reserve currency--oil and other commodities around the world are primarily priced in dollars. As world markets move away from dollar domination, however, particularly in favor of the euro and the pound sterling, demand for dollars will decline.

   Interest Rates

   • Another factor that influences demand for dollars is the interest rate paid on dollar denominated debt. This rate is influence by the Federal Reserve's overnight lending rate, but is actually set in the Treasury markets. The purchase of a Treasury bond is essentially a long-term investment in dollars, since the interest paid on the bond is in dollars and subject (in real value terms) to the fluctuations of that currency. Though the dollar is more attractive when interest rates are high, high interest rates make it difficult for the government to finance its deficits, and also weigh on economic activity. Low interest rates stimulate borrowing and drive economic activity, but at the cost of weakening the dollar.

   Speculation

   • Ultimately, since the dollar is not backed by anything other than faith in the U.S. financial system, the value of a dollar is not fixed, but rather fluctuates freely on currency markets. Thus, it is susceptible to patterns of currency trading, including speculation. The Treasury and the Federal Reserve occasionally intervene in currency markets to prevent unorderly and rapid dollar declines, and to maintain a stable currency market. Speculators attempt to gauge appropriate value of the dollar by comparing available supply to total economic output, interest rates, inflation risks and the relative attractiveness of other currencies.