Let's zoom way out and think about some foundational concepts, starting with what is money? Why do we need money and what is it good for? Money is the modern medium of exchange for settling transactions. So, what is a transaction and how do they operate? A transaction is the exchange of money or credit for goods or services. It's likely you participate in transactions quite often, for they allow you to buy goods & services you may desire or that make your life easier. Money is what you settle transactions with, and the reality is that most of what people call money is actually credit. Let's quickly differentiate.
When you buy a beer from a bartender with cash (money), the transaction is settled immediately. But when you buy a beer with credit, it's like starting a bar tab. You're saying you promise to pay in the future. Together you and the bartender create an asset and a liability. You just created credit. Out of thin air. It's not until you pay the bar tab later that the asset and liability disappear, the debt goes away and the transaction is settled. Credit will be covered more in depth in a later section. Let's focus back to strictly money for now.
So, what about before the existence of money and credit as we know it, how were transactions settled then? Before the development of a medium of exchange—that is, money—people would barter to obtain the goods and services they needed. Two individuals, each possessing some goods the other wanted, would enter into an agreement to trade. Early forms of bartering, however, do not provide the transferability and divisibility that makes trading efficient.
For instance, if someone has cows but needs bananas, they must find someone who not only has bananas but also the desire for meat. What if that individual finds someone who has the need for meat but no bananas and can only offer potatoes? To get meat, that person must find someone who has bananas and wants potatoes, and so on. The lack of transferability of bartering for goods is tiring, confusing, and inefficient. But this is not where the problems end. Even if the person finds someone with whom to trade meat for bananas, they may not consider a bunch of bananas to be worth a whole cow. Such a trade requires the parties coming to an agreement on value and devising a way to determine how many bananas are worth certain parts of the cow.
Commodity money came along and helped solve these problems. So what is a commodity in this context and how does it relate to money? A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type. Commodity money is a type of good that functions as currency. In the 17th and early 18th centuries, American colonists used beaver pelts and dried corn as commodity money in transactions. Possessing generally accepted values, these commodities were used to buy and sell other things. The commodities used for trade had certain characteristics: they were widely desired and, therefore, valuable, but they were also durable, portable, and easily stored. Commodity money has intrinsic value but risks large price fluctuations based on changing commodity prices. If silver coins are used, a large discovery of silver may cause the value of the silver currency to plunge.
Another, more advanced example of commodity money is a precious metal such as gold. What's interesting is that, unlike the beaver pelts and dried corn (which can be used for clothing and food, respectively), gold is precious purely because people want it. It is not necessarily useful—you can't eat gold, and it won't keep you warm at night, but the majority of people think it is beautiful, and they know others think it is beautiful. So, gold is something that has worth. Gold, therefore, serves as a physical token of wealth based on people's perceptions. This relationship between money and gold provides insight into how money gains its value—as a representation of something valuable (source).
In many cases, like the early days of the USD, people are not necessarily transacting with the commodity itself, rather they often use paper notes, backed by the commodity (e.g gold). Backing a currency with a commodity provides more stability and encourages confidence in the financial system. Anyone could take commodity backed currency to the issuing government and exchange it for the set amount of the commodity. We will see that eventually for convenience and to avoid commodity related price changes, many governments issue fiat money and no longer backed their currency with commodities (such as gold). So, what is fiat money and how does it differ from commodity money? Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. Fiat money only has value because the government maintains that value, or because two parties in a transaction agree on its value. At this point, the money increasingly takes on a value based on surrounding public confidence. Let's look at the journey of the USD from commodity money in the gold standard era to the modern non backed fiat money USD.
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, known as the gold standard. 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. It was 1933 the U.S. federal government stopped allowing citizens to exchange currency for government gold, although it still remained backed by the commodity at this point. In 1934, the government devalued the dollar to require $35 per ounce of gold. The gold standard, which backed U.S. currency with gold, was ended completely in 1971 by Richard Nixon when the United States also stopped issuing gold to foreign governments in exchange for U.S. currency.
Since Nixon's 1971 move, U.S. dollars are known to be backed by the "full faith and credit" of the U.S. government, "legal tender for all debts, public and private" but not "redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank," as printing on U.S. dollar bills used to claim. In this sense, U.S. dollars are now "legal tender," rather than "lawful money" which can be exchanged for gold, silver or any other commodity. (source). Legal tender is any currency declared legal by a government. Many governments issue a fiat currency and then make it legal tender by setting it as the standard for repaying debt. The current U.S. dollar as we know it is both fiat money and legal tender. As legal tender, the dollar is accepted for both public and private debts. (source). Nixon's 1971 move effectively delinked the dollar's value to the price of a tangible good and allowed it to float freely, changing circumstances around the "value".
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.
As noted above, from the period of 1834-1971 the USD was still backed under the gold standard, directly tying its value to gold. During this time, you could essentially calculate the "value" of one USD by referencing the price of gold and converting your USD to gold using that rate. 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, about 1.5 grams, or 371.25 grains of silver. In 1934 this rate changed to $35.00 per ounce, devaluing the USD. Upon decoupling the backing of the USD by gold, the "value" of the dollar is much trickier to determine at any given point since you cannot just convert it to gold.
For example, if you had $10,000 dollars and converted it to gold between 1834-1933 (at $20.67/ troy ounce) you could essentially turn that money in for 483.79 troy ounces. In 1934, when the rate changed, that same $10,000 would only convert to 285.71 troy ounces for you. Quite a dramatic difference at once.
Since 1971, the U.S. dollar's value is determined by the demand for it, just like the value of goods and services. There are three ways to measure the value of the dollar. The first is how much the dollar will buy in foreign currencies. That’s what the exchange rate measures. Forex traders on the foreign exchange market determine exchange rates. They take into account supply and demand, and then factor in their expectations for the future. For this reason, the value of money fluctuates throughout the trading day. The second method is the value of Treasury notes. They can be converted easily into dollars through the secondary market for Treasurys. The third way is through foreign exchange reserves. That is the amount of dollars held by foreign governments, and the more they hold, the lower the supply. That makes U.S. money more valuable. If foreign governments were to sell all their dollar and Treasury holdings, the dollar would collapse. (source)
International currency exchange rates display how much one unit of a currency can be exchanged for another currency. Currency exchange rates can be floating, in which case they change continually based on a multitude of factors, or they can be pegged (or fixed) to another currency, in which case they still float, but they move in tandem with the currency to which they are pegged. 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. (source)
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. 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. (source)