How is the US dollar supported?

How the values ​​of currencies arise

The dollar is rising and yet is undervalued, Japan is struggling with its yen, which is far too high, and China is resisting a yuan appreciation. Where does the value of a currency come from - and what does it mean for a country?

Basically, the lower the rate of a currency, the better it is for the country's exports; rising exchange rates are bad for exports. For example, suppose a television costs 200,000 yen. The starting rate is 1: 100, so you get 100 yen for one euro. So the television costs 200,000: 100 = 2,000 euros. If the yen rate rises to e.g. 1:80 (you only get 80 yen for one euro), the same television set with the same yen price costs 200,000: 80 = 2,500 euros. At this higher euro price, however, fewer televisions would probably be sold, because non-Japanese companies can keep their prices lower. Therefore, the European price of the Japanese television will remain (almost) the same on the market. As a result, the company in Japan receives less yen for its televisions sold in euros.

High exports can appreciate currency

At the same time, increasing exports can also lead to an appreciation of the currency. For example, if Japan exports more than in a previous period, buyers in other countries will have to buy more yen to pay their debts in Japan. The simple principle of supply and demand also applies to currencies to a limited extent. So if more yen are bought (more demand) and at the same time fewer are on the market (supply), the price rises - the yen becomes more expensive. That in turn is bad for exports (see above).

Prophecies often come true

Another important factor for the rate of a currency are market expectations - i.e. what price developments speculators expect. Suppose the majority expect the dollar to rise. In order to enjoy the price gains, many buy dollars on the market while it is still "cheap". So you are increasing the demand, which leads to a rising price - so the prophecies have fulfilled themselves.

Interest has a say

High interest rates also attract investors to a currency. Especially if the devaluation of your own currency is expected. A fictitious example with unrealistic but illustrative values: Assume that the exchange rate from dollars to euros is 1: 1.5, so for one euro you get 1.50 dollars. The savings book interest in the US is three percent, in Europe, however, four percent.

A European invests 100 euros in America. In return, he receives \$ 150 and three percent interest. So after a year it would have been \$ 154.50. If the exchange rate does not change, it changes the 154.50 dollars to 103 euros. In Europe, he would have saved 104 euros in the same period. However, if the euro were to devalue this year, e.g. to 1.40 dollars, it would change its 154.50 dollars to 110 euros. The ratio by how much which exchange rate has to fluctuate in order to have the same return in two countries with different interest rates is called interest parity.

If the euro were to rise, they would have to be able to offset the loss in exchange rates with even higher investment returns. This is also called "uncovered interest parity": domestic interest rate = foreign interest rate minus exchange rate loss

The power of the central banks

The central banks, for example the US Federal Reserve or the European Central Bank, also have an enormous influence on the value of a currency. You not only set the key interest rate and thus influence the exchange rate. Because of the enormous amounts of money they are working with in the markets, they also have the role of great investors. The central bank controls the amount of money in a region (e.g. Europe) mainly through "refinancing operations". A variable rate tender based on the American method is used for this purpose: the central bank specifies a minimum interest rate and the total amount of credit. Banks submit their bids for how much money they need and also state an interest rate that they are willing to pay.

Allocation of credits: Bids with the highest interest rate are fully honored. Then the second highest, etc. bids close to the minimum interest rate are only considered proportionally: only the volume that is left after the highest bids is distributed over them.

Real vs. nominal exchange rate

As with inflation, one can differentiate between a nominal and a real exchange rate. The nominal is the relative price of a currency - i.e. the price at which currencies are also quoted. For example, one euro is currently nominally worth \$ 1.38. The real exchange rate, on the other hand, is that for which one can "exchange" a good between two countries. An example: A car in Austria costs 10,000 euros. In the UK, the same car costs £ 8,000. The nominal exchange rate of the pound is 0.87 euros, so you calculate: 0.87 * 10000/8000 = 1.0875. That means that for the same amount of money in the UK you can get 1.0875 cars.

Currencies were once tied up

The fact that the values ​​of currencies fluctuate relatively freely has not always been the case. For example, the Austrian shilling was once linked to the German mark. Even earlier there was the "gold standard", also known under the agreements of Bretton Woods, a place in the USA. There it was fixed in 1944 that the currencies of 44 countries have a fixed exchange rate to the US dollar. Fixed means that the central banks had to keep the exchange rates of their currencies against the dollar stable by buying or selling foreign currency. At the same time, the United States committed itself to exchanging dollars for gold at any time - at a price of 35 dollars per troy ounce, which is almost amusing from today's perspective.

Richard Nixon released the dollar in 1971

A core problem, however, was the dependence on the economy in the USA: as long as the USA achieved surpluses in foreign trade, the system worked well - because the dollar was scarce internationally. But if the dollar amount increased, it was thanks to confidence in the currency. The phenomenon is known as the "Triffin Dilemma" named after Robert Triffin. In addition, the US got into an awkward position: in 1969 France wanted to redeem its dollar reserves for gold - but the US was unable to meet these contractual obligations. Thus, the US dollar no longer corresponded to the value that had been fixed in the Bretton Woods Agreement. On August 15, 1971, the then US President Richard Nixon finally announced the end of the obligation to exchange dollars in any quantity for gold at a fixed rate.

Seigniorage thanks to petrodollars

However, the US dollar is still the dominant reserve currency. This is not only due to the economic importance of the USA itself, but also to the "petrodollar": Worldwide, oil is mainly billed in US dollars. This brings the USA a lot of "seigniorage" income. These are the central bank's net income from issuing money - namely the cost of everyone else holding the central bank's money.

(ebl)