You Decide: What Determines The Dollar’s Worth?

By Mike Walden

I often receive comments from readers about my columns. Some agree with my comments, while others disagree. I value both, but some readers suggest a topic for a future column. Today’s column is based on one of those suggestions.

When we talk about the dollar’s worth or value, we’re really talking about how much the dollar will buy. There are two aspects to this question – one domestic and the other international, although as you will see, they are related.

Domestically, the dollar’s worth – or purchasing power – is directly related to inflation. When prices rise, the dollar buys less. This is actually OK as long as consumers’ incomes rise at a comparable rate.  

For most of the 21st century, the annual average of price increases was in the low single digits. Fortunately for most people – but certainly not for all – their earnings were rising at a comparable or even better rate. So even though the purchasing power of the dollar was dropping, people were earning enough extra dollars to keep up with the higher prices. For retirees on Social Security – like me – payments are actually indexed to inflation, meaning the amount of the payments automatically rises with the inflation rate.

When price increases accelerate, as they have done in recent years, fewer workers are able to keep pace with their wage gains. The declining purchasing power of the dollar, therefore, results in a lower standard of living.

The way to keep inflation modest, meaning the purchasing power of the dollar drops very slowly, is to have the supply – or quantity – of products and services growing at a pace that keeps up with an expanding population and more buying power. Unfortunately, this didn’t happen during the pandemic. 

Interruptions to the supply chains of many producers resulted in bare shelves and delayed orders. Furthermore, once the economy reopened, buyers had money to spend from the large amount of federal aid that had been provided during the pandemic to prevent massive destitution. The result was the classic “too much money chasing too few goods and services,” meaning inflation soared.  

The good news is supply chains have been improved, with some totally fixed. Also, consumer purchases have been slowing. The result has been a moderating inflation rate, meaning the dollar’s purchasing power is not dropping as fast as it was. Indeed, in March and April this year, average wage rates rose faster than inflation.

The second dollar value is its international worth. This value is measured by the number of units of a foreign currency that trades for one dollar. The more units of a foreign currency that equal one dollar, the “stronger” the dollar. The fewer units of a foreign currency that equal one dollar, the “weaker” the dollar.

However, tradeoffs exist in these currency relationships. If the dollar becomes “stronger” against a particular foreign country’s currency, then U.S. consumers can purchase more of that country’s products and services because they receive larger amounts of the country’s currency when exchanging dollars. This helps contain the U.S. inflation rate. In contrast, a stronger dollar makes selling U.S.-made products and services more expensive to foreign buyers, which can hurt U.S. companies.

U.S. monetary policy importantly influences both the domestic and international values of the dollar. Too much money availability can lower both values, while reductions in money availability can increase the values.

A century ago, most key countries were on a gold standard. The gold standard limited central banks – like our Federal Reserve – in printing money. The historical record shows that during the period of the gold standard, inflation was very modest.

However, the popularity of the gold standard changed with the worldwide Depression of the 1930s. The gold standard limited how much money a country could print and inject into the economy to assist households and businesses during the lean times. As a result, President Franklin Roosevelt effectively removed the country from the gold standard for the domestic economy. In the 1970s, President Nixon completed the discarding of the gold standard by eliminating it for international transactions.

There is an ongoing debate about whether we should return to the gold standard. Advocates see a gold standard as bringing back a time when inflation would never be a problem.

Yet there are others who see some big problems with the gold standard. As the economy expands and generates more transactions, more gold would be needed to provide additional uses of money. Where would the supplies come from?  

A gold standard would also limit the ability of the federal government to assist the economy during bad times, such as a recession. We saw the importance of this help during the COVID-19 pandemic. When a large part of the economy was shut down, federal relief programs provided resources for many businesses and households to stay afloat. A big part of these programs was effectively financed by the Federal Reserve through the printing of money.

I’ll end with two key questions. Can we contain inflation, have broad-based prosperity and maintain the ability of the federal government to respond to economic emergencies? Also, can these goals be achieved without returning to a gold standard? You decide.

Mike Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.