Question: How is the value of the U.S. dollar determined?
Answer: Simply stated, a dollar’s value equals how much “stuff” it will purchase. The more realistic response is what I hear whenever I ask our granddaughter Averie how her day went; “It’s complicated Yaya,” followed by a heavy sigh.
Explaining dollar valuation and why it matters can be awkward and confusing but it’s not impossible. For starters, the foundation of any currency depends on factors like supply, demand, exports, imports, foreign exchange rates and overall confidence.
Prior to 1973, U.S. dollar valuation was tied to the price of gold and dollars could actually be exchanged for gold until the system was terminated by President Nixon. At the time there was concern whether there was enough gold to back all the dollars in circulation. During this period the news of the day included oil prices, the Middle East, OPEC and Vietnam.To take the place of the abolished gold standard, the U.S. dollar index came about in 1973 with a base rate of 100. The index provides a measuring stick relative to these developed country’s currencies; the euro, Japanese yen, Canadian dollar, British pound, Swedish krona and Swiss franc. The weighting of each currency depends on its contribution to the world economy.
By the 1980s the dollar had lost half of its value. Much of this can be attributed to deficit spending used to fund the Vietnam War and stimulate economic growth. The circulation of more dollars in the economy from the issuance of Treasury debt created inflation. Inflation is the result of too many dollars chasing the price of goods and services in an upward direction. By the 1990s Reaganomics and tax cuts increased the deficit and inflation. We did balance the government budget in the 1990s, yet the money supply continued to expand.
It’s logical to expect that monetary expansion during the Great Recession of 2007-2009 would’ve devalued the U.S. dollar even more. But that’s not what happened. Because the U.S. dollar index depends on the value of the currency of other developed nations as outlined above, the dollar actually rose in response to financial problems in Portugal, Italy, Greece and Spain (PIGS). A “flight to quality” occurred with the dollar perceived as more stable than other currencies.
During times of uncertainty the dollar becomes a safe haven. Increased demand drives prices of the dollar up during times like the 2010 Greek Debt Crisis. Brexit was another event that drove up the valuation of the dollar, but that was a short-lived event as we realized that unwinding the relationship between the United Kingdom and the European Union would take a great deal of time to accomplish. As Averie says, “It’s complicated Yaya!”
Most international trade transactions are settled in U.S. dollars requiring other countries to keep dollars on hand. China and Japan export a great deal to the U.S. and have stockpiled a bunch of dollars. These are effectively out of circulation, keeping the value of the dollar higher.
This keeps Japanese exports less expensive and provides the country with an economic advantage. When the dollar falls, our exports become less expensive and when the dollar increases, our exports are more expensive, making the exports of other countries, in this example more attractive.
A lower dollar can also translate into higher prices for overseas travel. Meanwhile it would help U.S. based manufacturers with exports while it could also make it more difficult to maintain your desired quality of life as it becomes more expensive as a lower dollar buys less. Some believe that one way to change this is by increasing wages. But this would likely cause prices to increase. Are you beginning to see why I say that it’s complicated?
If we add the stock market to the discussion, we can say that although it may have been less volatile than expected, movement is occurring in the currency markets. Inflation is related to the value of the dollar. Although we may not hear that inflation is high, a declining dollar is inflationary as it diminishes purchasing power.
The value of the U.S. dollar is dependent on many factors. Understanding how the various relationships influence markets, prices, and purchasing power is an important piece of your investment puzzle. The success of your financial plan is measured in steady progress towards your unique goals. This often requires that a portfolio keeps up with or exceeds the rate of inflation, which is closely tied to the value of the dollar. Watch for shifts in trends that could affect your financial plan in the long run. Stay focused and invest accordingly.
Past performance does not guarantee future results. All investments are subject to risk. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. This information should not be construed as a recommendation of any investment strategy or product. Views expressed are the current opinion of the author and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. There is no assurance these trends will continue or that forecasts mentioned will occur.
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This article is provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. Call or email Darcie at 239-389-1041 or firstname.lastname@example.org with questions or suggestions for future columns. Visit her website: www.raymondjames.com/Darcie.