How USD became so Powerful?

The United States is the biggest economy in the world, with a GDP of $26.7 trillion in 2023. The USD is one of the many reasons for the US becoming a global economic giant. U.S. dollar is the most potent currency in the world. The value of a currency depends on many factors, such as the country’s financial health, supply and demand, the sentiment of the people on the currency, and market drivers of exchange rates. Dominating all these factors is how USD became so powerful.

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How is the Value of USD decided?

In general, the value of a currency is decided by three factors: exchange rate, foreign currency reserves, and economic condition. However, in the case of the U.S. dollar, apart from these factors, certain other factors also play a role in deciding its value. The following are major factors responsible for determining the value of the U.S. dollar.

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1. Exchange Rate

The exchange rate is the relative value of a currency to another currency. The U.S. dollar stands at the 10th position in this tool of measurement. In forex trading, the relative values of currency are joined together to form currency pairs (for example, EUR/USD).

The U.S. dollar index (DXY) is the most potent indicator to gauge its value in foreign exchange. When DXY is strong (high in number), the value of the U.S. dollar is high. 164.7 is the highest value DXY achieved in history in February 1985, meaning the U.S. dollar had the highest value. Currently, DXY is fluctuating between 104 and 105.

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Moreover, the exchange rate is influenced by certain other factors:

• A country’s interest rates influences the currency’s value; raising interest rates increases the currency’s value.
• The condition of economic health of a country also influences a currency’s value. A strong economy ensures a strong currency.
• Trade and debt also play a crucial role in deciding a currency’s value. Trade surplus and low debts support the value of a currency.

2. Foreign Exchange Reserves

The U.S. dollar is a global currency; more than fifty percent of international trade is done with USD. This raises the demand in other countries to accumulate dollars as reserves to ensure smooth trade with other countries. This stockpiling of USD by other countries in their currency reserves is called foreign exchange reserves. The countries with a trade surplus acquire more USD than they spend on imports, so they keep the extra earned USD as forex reserves for the future. High USD reserves ensure smooth trade with other countries and support the local currency at a stable value.

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Moreover, other countries prefer to diversify their foreign exchange profile (reserves in different currencies and gold/silver) to reduce too much reliance on a single currency.

Japan and China are the largest reserve holders of USD.

3. The Trust in the U.S Government

Trust in the U.S. government by the people plays a crucial role in deciding the value of the U.S. dollar. If people trust the government, internal and external investors show confidence, eventually increasing the demand and value of USD.

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If there is trust in the government’s ability to manage its debt responsibly, it can positively influence the value of the U.S. dollar. Investors assess whether a government is likely to meet its debt obligations. If there’s confidence in the government’s fiscal policies and the ability to control and reduce debt levels, investors may be more willing to hold U.S. assets. Countries with lower levels of perceived risk related to government debt are often viewed more favorably by investors. This positive perception can contribute to increased demand for the U.S. dollar.

Moreover, a sense of perceived security is established when people trust their government, leading to an increase in capital flows into the country, which increases the value.

How USD became so Powerful?

The U.S dollar became the global currency because of its dominance over other currencies; the factors that helped the USD gain such dominance are:

1. Economic Strength Post World War II

After World War II, the United States experienced a significant economic boom and emerged as the world’s largest economy. The war wreaked havoc on Europe and Asia, leaving the United States relatively less damaged and superior in both industrial infrastructure and technological advancements. The Marshal Plan of European Reconstruction dominated the United States both culturally and economically over Europe.

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2. The Petrodollar System

The Petrodollar system was introduced in the early 1970s when major oil-producing countries agreed to trade oil exclusively in U.S. dollars. With increasing industrial needs, requirements for oil increased in all major developing countries. This hiked the oil demand, ultimately for USD. Countries consistently struggled to gather USD for a smooth oil supply to meet their needs. Thus, the petrodollar was among the primary reasons for gaining global dominance.

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3. Convertibility to Gold Factor

Until 1971, the U.S. maintained gold as a standard against the dollar, which allowed foreign governments to exchange dollars for gold. The U.S. government promised to exchange dollars for gold at a fixed rate of $35 per ounce. This provided confidence in the stability of the U.S. dollar and supported its global acceptance.

4. Dollarization of Economies

Post 1970, countries started to back their currencies in U.S. dollars instead of gold. The U.S. government also moved from supporting gold to a sovereign guarantee from the government. Other countries started stockpiling USD to stabilize their currency. This surged the demand for USD, ultimately boosting its value. According to Investopedia, more than 65 countries have pegged their currencies with USD.

5. Financial Innovations

Developing financial markets and instruments, such as new financial products or technologies, can influence investor confidence. The introduction of U.S. Treasury bonds and the rise of New York as a global financial hub contributed to the widespread use of the dollar in international finance. The New York Stock Exchange and forex market still play a significant role in the global economy.

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6. Huge Size and Openness of U.S. Markets

The US is the 3^rd largest consuming market in terms of the number of consumers and the largest consuming country in terms of household financial consumption expenditure in the world, even though it lags in population to China and India by a considerable margin. The US market offers a lot for investors. This factor, coupled with economic liberty and political stability, attracted investors to invest in the US market, strengthening the USD’s value.

The Bottom Line

The United States is the biggest economy in the world, and the U.S. dollar is the most potent currency. Many factors decide the value of USD, but the exchange rate, foreign exchange reserves by other countries, and the trust of the people of the US in the US government are the most relevant factors. Dominating factors such as economic activity, the petrodollar system, convertibility to gold, financial innovations, and dollarization of other countries’ reserves are how the USD became so powerful.