What Makes the Dollar Fluctuate?

There are many reasons why the dollar might fluctuate in relation to other currencies. Generally speaking, the dollar will grow stronger when there is an increase in the demand for dollars for either transactional or speculative reasons, and weaker when there is a decrease in the transactional or speculative demand for dollars.

Trade Imbalances

Trade imbalances are a primary reason for currency differences. Foreign investors--including firms, individuals, and governments--seek U.S. dollars to buy U.S. exports and other assets such as securities. When U.S. exports and assets become cheaper, imports and foreign investments become more expensive, and the dollar may weaken. Foreign investors have more dollars to purchase U.S. goods and services than vice versa. In contrast, when imports and foreign assets become cheaper, exports and U.S. investments become more expensive, and the dollar may strengthen in relation to foreign currencies. When a country imports more than it exports, they have a trade deficit, which means a country is buying more than it is selling. When the country exports more than it imports, they have a trade surplus.
Both trade deficits and surpluses are indicative of how much money a country has for transactional purposes, which directly impacts the country's ability to grow. If a country enjoys a trade surplus, it can put the extra revenue to work to create more wealth. The amount of money coming into or leaving the U.S. can cause the dollar to fluctuate.

Speculation

Financial institutions place huge bets on the value of the dollar and other currencies through currency speculation--buying substantial amounts of a currency in the hopes of its appreciation, or buying options contracts that allow them to buy or sell currencies at a certain date at a certain price. Massive speculation can have substantial impact on the currency of an economy; for example, downward pressure on the dollar through bearish speculation, coupled with other poor economic conditions can cause financial crises. Speculation is another primary cause of the dollar's fluctuations.

Interest Rates

The U.S. Federal Reserve has several instruments available to direct monetary policy, chief among them the setting of interest rates. Its ability to influence the federal funds rate, coupled with the ability to set the discount rate, ostensibly allow it to set the baseline interest rate at which banks will make loans available to individuals and businesses. When interest rates are low, money, in the form of credit flows freely; when they are high, money is in shorter supply. Interest rates can cause the dollar to fluctuate depending on whether it loosens or restricts the amount of money flowing through the system.

Open Market Operations

The Federal Reserve can also implement monetary policy through open market operations, which involve the buying and selling of Treasury securities. Buying securities raises the money supply; selling securities lowers the money supply; either one can cause the dollar to fluctuate.

Reserve Requirements

A third instrument of the Federal Reserve is the ability to set capital requirements for the country's banks. Reserve requirements play a limited role in the expansion or contraction of the money supply, however it can be used in conjunction with the aforementioned tools to increase or decrease it. As such, reserve requirements play a role in the fluctuation of the dollar.

References

• Why do dollar rates fluctuate? - BrookesNews.com

Resources

• The Federal Reserve Board