Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Why a Dollar Isn't Always Worth a Dollar

We're so used to carrying and exchanging the American dollar bill, we rarely take a moment to actually look at it. There's the eagle, George Washington, that spooky eyeball and of course, the number, "one."

But any student of the markets knows that currency values change, and so a dollar isn't just worth a dollar all the time. Sometimes dollars are worth more, and sometimes they're worth less.

How can this be? Why was it, for example, that when you traveled to Europe on vacation last summer the bank gave you more Euros when you exchanged $100 on Monday than when you exchanged $100 on Tuesday? And why are financial reporters and pundits always talking about the dollar "slipping" or "gaining"?

Here are some basics to explain how the dollar rises and falls.

Isn't a Dollar Always Worth... A Dollar?

Sort of. The dollar is a fiat currency, which means that each little greenback is not backed by gold, silver or other "hard" asset. It simply has value because people say it has value.

Accordingly, that value depends on the strength of the economy that issues the currency. Sure, the dollar bill says it's worth a dollar, but because economies depend on other economies, the value of that piece of paper depends in large part on the value of other currencies. In short, a dollar has value based on its worth relative to the worth of other currencies.

It helps to remember that currency is a commodity, like orange juice. In the trading markets, they're more of an object than a concept. When you're exchanging your dollars for yen, for example, you're "selling" your dollars and "buying" yen the same way you would be if you were "selling" your dollars and "buying" orange juice.

We all learned in economics class that when the demand for something goes up, the price goes up with it. So in our case, if everybody is trying to "buy" yen (that is, convert their currencies into yen), the price of yen is going to go up. You might be able to buy a yen for about 1.3 cents today, but if everybody else is competing with you to get their hands on yen too, then the price could rise to, say, five cents. In other words, you used to be able to get 77 yen for $1, but now you can only get 20 for $1. Your dollar is worth less because the yen is worth more.

Why would everybody suddenly want to buy yen or euros or pounds anyway? There are a lot of potential answers to this question, but one that interests us right now has to do with being able to predict market changes. If you can figure out what will make the price of a particular currency move, you're in a position to make a lot of money.

Here are some basic influencers.

Interest Rates: Demand for most of the world's currencies is largely a factor of interest rates. When interest rates are relatively high in a particular country, everybody else wants to invest there so they can earn the higher rate.

To do this, they might borrow money in their home countries and then invest it in bonds or other accounts issued by a bank the foreign country. Of course, in order to take advantage of the higher interest rates, they have to buy the foreign currency first. And that creates demand for the currency, which raises the price of the currency. So, when interest rates are rising in a country, the value of its currency is probably going to rise as well.

Thus, the real task becomes figuring out how to predict what will make interest rates become relatively higher in a particular country. A wide variety of factors could contribute to that, though many economists watch the country's central bank.

Central banks (and the treasuries they work so closely with) control most of the execution of a country's fiscal and monetary policies. Sometimes, for example, a central bank wants to lower the interest rates in order to stimulate lending and investment in its country. This may make it cheaper for that country's citizens to get a loan or a mortgage, but it also means its savers and investors are earning less on the money that they're saving or lending to other people (in the form of bonds). It's no surprise then that when a central bank lowers interest rates, the value of the currency also takes a hit as people begin investing in other countries that offer bonds or other investments with higher interest rates.

Remember, though, that it's all relative. If a bunch of other countries' central banks lower their interest rates but one country's central bank does not, that one country's interest rates appear relatively higher than the rest and the capital inflows (and currency appreciation) begins. So in some cases, it's what a central bank doesn't do that can influence currency values around the world.

#-ad_banner_2-#Political Instability and Financial Crises: When a country's government or economy has deteriorated to the point that people are willing to flee the country, or foreigners can't or won't buy things made in that country (perhaps due to trade sanctions, new tariffs, or other impediments on trade), the value of that country's currency often suffers. That's because when people want to "pull out" of politically unstable countries, they want to sell that currency and buy another currency. This glut of currency for sale drives the price down. Widespread scandals, suspicious or unexpected elections, recessions, or other big financial problems have the same effect.

Interestingly, the currencies of other countries or economies that are considered more stable tend to benefit in this situation. In particular, the U.S. dollar, which is traditionally considered a "safe" currency, tends to see more demand (and thus gains in value) when political instability occurs in other countries.

Printing Presses: When a country's treasury prints more money in order to repay debt, buy stuff, or do something else, the value of the currency falls. That's because when more dollars are available to everyone, more spending occurs, and the increased demand for goods and services across the board raises prices. This is the essence of inflation: what used to cost only $2 now costs $3.

Because a U.S. dollar in this situation isn't worth as much (that is, it's cheaper), foreigners can get more of them when they exchange their own currency for greenbacks. So whereas it used to take 77 yen to buy $1, it might now only take, say, 50 yen -- thanks to the U.S. Treasury printing so many dollars.

For people who normally live and trade in yen, dollar-denominated American goods suddenly seem a lot cheaper and so they demand more of them. Anybody who lives near the Canadian border has probably witnessed this idea in action: sometimes it's cheaper to buy things in Canada, and sometimes it's not. Some years it seems like all of Canada is driving to Buffalo to shop, and some years there's an American invasion of Toronto shopping malls instead. This leads to another big influence on currency values: international trade.

Trade: A trade deficit occurs when a country imports more stuff than it exports. In the United States, for example, this typically occurs because foreign-made goods that are brought into the United States are much cheaper than goods that are made in the United States. Often, the foreign goods are cheaper because the labor costs in foreign countries are much lower. Other times, the foreign goods are cheaper because the dollar is relatively much stronger.

Sometimes, however, the foreign producer has some sort of technological or intellectual-property competitive advantage. An American company, for example, might see huge demand for its new widget. In order to acquire those products for its customers, retailers in foreign countries might need to purchase the widgets with dollars, which means the demand for dollars -- and thus the value of the dollar -- will increase.

That's not really the whole story, though. Think about all of the everyday products we buy from overseas that are cheaper than their locally-made counterparts -- clothes, electronics and auto parts, for example. As you can guess, when the dollar loses value (that is, when American-made stuff gets relatively cheaper), American exports tend to increase.

The opposite is also true, however: When the value of the dollar rises, the prices of dollar-denominated things are harder for U.S. exporters to sell overseas. That's why companies that rely on foreign customers are always sweating over the currency markets. If their home currency rises in value, they could be toast.

The Investing Answer: As you can see, the value of any country's currency lies in its worth relative to other currencies. If the dollar rises in value, it buys more (i.e. your dollars stretch further) in another country -- meaning you'll get some great deals if you want to retire or go on vacation in that country. If the dollar falls in value, our products and services become cheaper to other countries -- which makes it a great deal for foreigners to travel or do business in our country.

In turn, when you're investing, you should never just look at one currency by itself; always compare your own currency to the foreign country's currency to determine which currency is stronger, and make a decision from there.