Balance of Trade
The value of currency is ultimately determined by what the currency will buy. Individuals must have confidence that the currency will still be redeemable in the future and will buy goods and services now and in the future. Thus, buyers of United States dollars must have confidence that the United States will exist in the future and will provide value for their dollar investments at all time. Countries increase their wealth by increasing the amount of goods and services they supply domestically and internationally. If a country like the United States is successful in selling their goods and services, they receive payments from around the world in their own currency. Thus, there is a net demand for dollars relative to other currencies, and thus the value of the dollar rises. This means that the dollar can buy more yen, Eurodollars or British pounds. As a result of the increasing demand for dollars, the price for the same goods and services rise not because costs have gone up to produce the goods and services, but because there is a scarcity of dollars to pay for the produced products. The net effect effect of trading between various countries and the United States is the balance of trade. In a way, the "who" who determines the value of U.S. currency is the dollar itself, as every merchant and individual around the world votes for the dollar with each purchase made with a U.S. dollar.
Effects of Inflation and Deflation on U.S. Currency
When the United States chooses to borrow from the public both domestically and internationally, the borrowed monies are used to pay for government services. These services are paid for in dollars. In essence the government has created dollars without producing any goods and services---it has borrowed the production of goods and services of others. Until these dollars are paid back, there are more dollars circulating for the same amount of goods and services. Thus, with more dollars to purchase the same amount of goods and services, the rate of inflation rises. Similarly, a reduction of the number of dollars available (caused from a decline in wealth from house values, for example) with no decline in the production of goods and services will cause deflation. Currency values remain steady when neither the imbalances of inflation or deflation are occurring.
Short-Term Effects of Interest Rates
When inflation is high, the Federal Reserve Bank, in coordination with other central banks, raise interest rates until consumers of goods and services choose to become savers instead. As demand for goods and services falls, so do prices. Savers from around the world buy U.S. dollar-denominated investments. This tends to make the United States dollar stronger, as it did dramatically in the early 1980s, when short-term interest rates reached 20 percent. The result is that the dollar buys more foreign goods but there is little demand for foreign goods. Investors prefer to reap the benefits of savings. When the dollar has had an extended slide in value through low interest rates and lack of demand for United States-produced goods, the value of U.S. currency slides precipitously. The result is a weak dollar because it can buy fewer and fewer foreign goods and services.