[Jthomp76]

I consistently see two opposing views of the dollar’s fate when reading libertarian leaning opinions. One says the dollar will collapse and massive inflation will ensue because of all the money printing. The other says this will not happen because all other countries are doing the same thing. A currency’s value is a relative quantification. We can debase like crazy without collapsing the dollar so long as all other currencies are also being debased. I tend to believe the former but have to admit the latter seems to have legitimacy given the low inflation rate we have despite massive money printing. Help!! I don’t know what to think!!

[jmherbener]

Like any other good, money’s exchange value or price is determined by its total stock and the total demand people have to hold the stock. Each fiat currency of the world has a price or purchasing power within the area in which it is legal tender money and a price or exchange rate against each of the other currencies in the world. Exchange rates adjust to keep the purchasing power of any one currency, say the dollar, the same everywhere. So with the demand for all the currencies held constant, if the Fed inflates the stock of dollars to a certain extent and every other country inflated its currency to the same extent, then every country would experience price inflation domestically and yet the exchange rates between currencies would be stable. If the Fed massively inflated dollars, then we would have hyperinflation domestically. If other countries only modestly inflated their currencies, the our hyperinflation would be associated with dollar devaluation against other currencies. If other countries massively inflated their currencies, then our hyperinflation would not have dollar devaluation against other currencies.

What has been moderating our price inflation in the face of Fed monetary expansion is an offsetting increase the demand to hold dollars. The monetary policy of other countries cannot affect the purchasing power of the dollar unless it affects the demand to hold dollars. Lacking this, monetary policy of other countries will affect exchange rates, but not the purchasing power of the dollar. Faster inflation of a foreign currency relative to the dollar will result in an appreciating dollar relative to the foreign exchange and vice versa for slower inflation of a foreign currency relative to the dollar.

[Jthomp76]

So are you saying that the exchange rate has nothing to do with price inflation is the U.S., for example? If China buys up a lot of our dollars, does that not take them out of circulation here in the sates?

[jmherbener]

If the Chinese, or anybody else, hold more dollars, then the purchasing power of dollar will be higher than otherwise. Whether or not they exchange rate changes in response depends on the purchasing power of the yuan as well. The exchange rate will adjust so that the purchasing power of the dollar is the same in the U.S. as it is in China. Otherwise, people will gain by shifting their demands away from where the dollar buys less to where the dollar buys more.

[Jthomp76]

Is this why China and other countries purchase so many US Treasuries? Are they increasing the demand for dollars (and the purchasing power) by doing so?

[jmherbener]

When the Chinese buy and hold U.S. Treasuries, they are not holding dollars. They sell yuan to acquire dollars and then spend the dollars to buy the securities. The dollars, then, go back to the U.S. Treasury. The same thing happens, when the Chinese buy real assets in America, like golf courses. The Chinese buy and hold securities to earn the rate of interest. They buy and hold American golf courses to earn the rate of return on their investment.

What affects the purchasing power of the dollar is the total stock of dollars and the total demand to hold dollars themselves. Since the early 1990s, the majority of dollars, the actual, physical currency, has been held overseas. Today more than 60 percent of all dollar currency is held overseas. It is this demand to hold dollars that affects the purchasing power of the dollar. Imagine what would happen to its purchasing power, if foreigners suddenly decided they no longer wanted to hold any dollars and they were all repatriated to the U.S..

[Jthomp76]

If the dollar is the worlds reserve currency, why do the Chinese buy so many low yielding US treasuries? Why not purchase things it needs instead? Why do they want our bonds? Is it all part of the monetary game countries are playing today? In other words, Is it that they want to keep the dollar strong, so they hoard the dollars? And they prefer the yield treasuries bear to dollars just sitting in reserve?

[jmherbener]

Some U.S. Treasuries held overseas are owned by private parties and some by governments. Private parties hold them for the same reason that private parties in the U.S. hold them, they are perceived as highly liquid, low risk assets. Foreign government hold U.S.Treasuries for both political and economic reasons. You have to investigate each case to find out what the reasons are. Here is an article a bout Belgium’s recent buying spree:

http://www.economicpolicyjournal.com/2014/05/peter-schiff-belgian-bond-buying-mystery.html#more

Here are the foreign holdings of U.S. Treasuries by country:

http://www.treasury.gov/ticdata/Publish/mfh.txt

Some U.S. dollars held overseas are owned by private parties and some by governments. Private parties hold them because they serve as a medium of exchange and store of value. Foreign governments have political as well as economic reasons for holding U.S. dollars. You have to investigate each case to discover the reasons.

Here’s an analysis of foreign dollar holdings in 1996:

http://www.federalreserve.gov/pubs/bulletin/1996/1096lead.pdf

Here’s a more recent analysis:

http://www.federalreserve.gov/pubs/ifdp/2012/1058/ifdp1058.pdf

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