What Causes the Dollar to Go Lower?

The dollar drops when the supply of dollars is greater than demand.

The dollar operates in a free market, and its price is determined by supply and demand. The main factors that influence supply are Federal Reserve action, loan demand and trade deficits. Interest rates, economic performance, trade surpluses and credit rating influence demand. The dollar drops because the U.S. usually runs a large trade deficit but doesn't collapse completely because the U.S. has a very high credit rating.

The Economy

When an economy grows, there is more economic activity and the demand for currency increases. In the U.S., the Federal Reserve (the Fed) increases the money supply to match economic growth by issuing more currency. The Fed also increases the money supply during economic slowdowns, and holds the money supply steady or increases it more slowly during rapid growth and inflation. The dollar would normally tend to go up during periods of growth, but the Fed's corresponding increase in the money supply generally keeps the dollar from rising.

Trade

The main reason the U.S. dollar drops is because the U.S. generally runs large trade deficits. When the U.S. buys more goods and services outside the country than it sells to other countries, it spends more than it earns. The extra money it spends, is extra supply outside the country, and this tends to make the dollar drop. Luckily there is a big demand for the U.S. dollar due to the perceived safety of dollars. As a result, the dollar drops relatively slowly.

Interest Rates

A separate influence on currencies is the interest rate paid on bonds from a particular country. If the interest rate is high, there is more demand. Investors buy the currency so that they can buy the country's bonds and earn the high interest. The U.S. has generally not had high interest rates in comparison to other countries. The dollar drops when U.S. interest rates are low.

Loan Demand

If interest rates are low and an economy is starting to expand, there is an increase in loan demand. An increase in loans boosts the supply of a currency because the borrowers will be spending the money they have borrowed. This would tend to make a currency drop in value. Internationally, bond purchasers will tend to borrow in currencies that have the lowest interest rates, such as the Japanese yen, and use the money to purchase bonds with high interest rates, such as the Australian dollar. When an unexpected event happens, bond holders may try to liquidate their positions quickly but they will have to buy the low-interest currency to pay back the low-interest loan. This can lead to large, short-term fluctuations where the dollar or other currencies rise and fall rapidly. Long term, it is the factors detailed under Steps 1 to 3 that will govern a currency's performance.

References

• The Federal Reserve System: Purposes and Functions
• Bloomberg: Dollar 'Panic' Drop to 74 Yen Likely in 2011, Wakabayashi Says
• CurrencyTrading.net: 50 Factors that Affect the Value of the US Dollar