Money impacts just about everything we do. It not only allows us to buy the basic necessities we need to live, but it also creates a sense of stability and security for ourselves and the overall economy. Yet, money is really just a piece of paper, so where does the value of a dollar bill come from?
The dollar of today has value because our society has agreed to give it value. But that wasn’t always the case. The currency that we know today as the US dollar emerged from a storied past.
US Monetary System
The earliest attempt to use paper money began in 1690 when the Massachusetts Bay Colony issued paper notes to finance a military expedition into Canada. Other colonies soon followed, issuing their own version of paper money.
Historically, paper money was nothing more than a promise to pay at a later time. While these notes should have been backed by coins, or gold and silver, most weren’t. These notes lost value quickly and soon weren’t worth the paper that they were printed on.
The first national American currency, known as “continentals” were intended to finance the American Revolution in the 1770s. However, the rapid pace of printing eventually made these notes worthless.
While attempts to create a central bank followed, people feared the size and power of this new organization. Instead, state banks and unchartered banks began to issue their own notes. Yet, it was not until the National Banking Act of 1863 was passed, a uniform currency began to take shape. 50 years later, the Federal Reserve System was created to maintain the stability of the financial system through setting monetary policy and supervising banking institutions. People then became more willing to use the US dollar bill as currency.
As the US dollar became more widely used, the United States had to continue making changes to its monetary policy to create greater economic stability during both bad times, and good.
Why Does the Value of a Dollar Change?
The value of the US dollar continues to change—but why? Though there are a variety of reasons, it typically fluctuates based on economic activity, as well as changing consumer behaviors or current events. This can include anything from how consumers spend their money to how the US dollar compares to the value of other currencies around the world.
The value of the US dollar may change according to:
- Money supply - If too much money is in circulation, more money is available to be used, and each dollar can become less valuable.
- Market imbalances in goods and services - Demand for and supply of goods and services fluctuates. If demand is greater than supply for a long period, this drives up prices and makes the dollar worth less money. Conversely, if the supply of goods is greater than demand, the dollar may increase in value because you can buy more with it.
- Relative valuation - Global currencies are measured against each other on global markets. If the US dollar is weaker compared to other currencies, its value falls.
- Rising unemployment or economic uncertainty - Uncertainty may cause consumers to stop spending. Less money in circulation may drive up the value of the dollar.
The value of the dollar may also change with interest rates. When interest rates rise, the value of the dollar typically increases. When it costs more to borrow money, people tend to spend less and this drives up the value of the dollar. On the other hand, when interest rates fall, people may be more willing to spend money, and as a result, we can see the value of the dollar drop.
What Is Inflation?
Simply put, inflation means your dollar can’t pay for as much today as it did yesterday. Essentially, the value of the dollar falls as the prices of goods and services increase. This can happen when demand exceeds supply, pushing up prices, and can also happen as production and raw materials costs increase.
Generally, the decrease in the purchasing power of the dollar can be offset by rising income. If $1 buys fewer goods and services, it also buys less labor. To make up for this declining value, median incomes would rise. But if wages don’t keep up with rising prices, people have less money to buy goods and services.
As the US has experienced periods of steady inflation, extreme inflation, and even deflation over the last century, consumers have seen the value of their money decrease and the cost of goods and services increase. We can clearly see this when looking at how much something was worth almost 100 years ago compared to today.
For example, let’s compare the price of a home in 1950 to the price of a home in 2021. In the 1950s, the average price of a house was around $7,000, which has a purchasing power of about $79,000 today. If you jump 70 years to 2021, the average price of a house is about $269,039, worth a whopping $3 million in 1950. So, by looking at this example, you can see how inflation can significantly affect the overall economy, which in turn impacts the consumer as we see a rise in costs over time.
The Importance of Investing and Compounding
One way to protect yourself against the dollar's declining value is to invest your money. The return on your investment may be enough to offset any drop in value from inflation.
Choosing to invest or put your money in a high-yield account—like a money market account or Teachers Smart Checking account—that compounds interest to help you combat a declining dollar. Compounding builds interest not just on the money you deposit but also on the interest that you earn. This helps your balance grow, and over time, the interest on interest earned actually drives most of the growth in your balance.
The Value of the US Dollar: What’s In Store For the Future?
A drop in the value of the dollar may not seem like a big deal. But over time, it can lose considerable value. Using a 2% inflation rate—the Federal Open Market Committee's (FOMC's) inflation target—the value of the $1 today will be worth just $0.55 in today's terms by 2050. Investing your money now can help to protect your savings against declining value.