The dollar's worth is determined by the amount of goods, services and foreign currency it can purchase. The value of the dollar can change significantly over time. To illustrate, according to the Vice Chair of the Federal Reserve Board, the exchange rate of the dollar against major foreign currencies declined more than 10 percent between the middle of 2010 and the spring of 2011. There are several reasons why the dollar appreciates and depreciates.
Prominent economists such as the late Milton Friedman have claimed that an increase in the supply of dollars causes their value to decline, and vice versa. The total amount of dollars is included within four specific financial measurements labeled M0 through M3, with the tightest definition of money being M0 and the broadest M3. For example, the M2 metric represents the total amount of dollars in global circulation, including checking and savings accounts. M2 amounted to $1.874 trillion in February 2011, according to the Federal Reserve Board.
Another important influence on the dollar's value is inflation, which refers to the cost of goods and services. The more dollars it takes to purchase items, the lower the value of the dollar becomes in terms of purchasing capacity. Inflation is measured using economic assessments of cost such as the Bureau of Labor Statistics' Consumer Price Index. If the dollar depreciates, or appreciates at a slower rate than inflation, then the dollar's worth does not keep pace with cost-of-living increases.
Video of the Day
Interest rates also cause the dollar to appreciate and depreciate in value. This is because interest rates affect the cost of borrowing money. When monetary policy allows interest rates to be low, the money supply increases due to the lower cost of borrowing. Low interest rates can also lead to inflation because an increase in wealth corresponds to a higher demand for products, which means more dollars are required to purchase the same things. As interest rates rise, the dollar is more likely to appreciate in value.
The U.S. economy is correlated to the value of the dollar, according to Owen F. Humpage and Michael Shenk of the Federal Reserve Bank of Cleveland. Moreover, confidence in the economy leads to investment, which itself increases the cost of U.S. assets including the dollar. For example, international banks invest in dollars as a reserve currency; when the U.S. economy performs well, the amount of these reserves are more likely to increase, placing an upward pressure on the value of the currency.