Investors often hear about how the dollar is strong at one time or weak at another, but the mechanics of how the value of the U.S. dollar is determined are more complicated than many realize. The history of money in the U.S. has some interesting twists in this regard, and the way that the value of the dollar was determined as recently as 45 years ago is far different from the system that prevails today.
The dollar and the gold standard
Prior to 1971, the U.S. government set the official value of the U.S. dollar by tying it to a fixed amount of gold. Congress set the amount of gold required in official money, and for a century, the Coinage Act of 1834 effectively set a fixed gold price of $20.67 per ounce. This set the official value of the dollar at 23.2 grains of gold, or about 1.5 grams, or 371.25 grains of silver, equal to just over three-quarters of a troy ounce.
That rate lasted until 1933, when President Franklin D. Roosevelt required all Americans to turn in gold coins to the Federal Reserve in exchange for paper money. In 1934, the government devalued the dollar to require $35 per ounce of gold.
In 1971, President Richard Nixon took the U.S. off the gold standard, saying that the U.S. would no longer convert dollars to gold at a fixed value. That move effectively delinked the dollar's value to the price of a tangible good and allowed it to float freely.
Foreign exchange markets
Since then, the U.S. dollar's value has been determined through trade in the foreign exchange markets. Participants in those markets tend to use a variety of factors in determining what positions to take, including the relative economic strength of the two countries, interest rates, and other macroeconomic factors.
From time to time, central banks will intervene in the currency markets to counteract volatility. For instance, in 2015, Mexico's central bank chose to sell $200 million in U.S. currency on a daily basis for a three-month period to purchase Mexican pesos. This move raised the value of the peso and reduced the relative value of the U.S. dollar. However, such interventions are now relatively rare in most free-market countries.
Similarly, some foreign countries have maintained a peg to the value of the U.S. dollar. For instance, Hong Kong has maintained a pegged rate since 1983, with 7.75 to 7.85 Hong Kong dollars equal to the value of one U.S. dollar.
There's no direct mechanism for establishing the value of the U.S. dollar. Although central-bank interventions in foreign exchange markets occur occasionally, the role of government in setting the dollar's value is a thing of the past.
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