How Does the Government Regulate Exchange Rates?

For example, if it lowers the rate, that drives down interest rates throughout the U.S. banking system. It also reduces the supply of money. Both of these results make the dollar stronger relative to other currencies. That's because U.S. dollar-denominated credit has become more expensive.

At the same time, dollar-denominated assets generate a higher return. Both create more demand for the dollar, while taking it out of circulation. The laws of demand and supply tell you that less supply and more demand drives up the price.

When that happens to the dollar, it can purchase more foreign currency on forex markets.

Treasury Department Role

The Treasury Department is a government agency that also indirectly affects the exchange rate. It prints more money. This increases the supply and weakens the dollar. It can also borrow more money from other countries. That's done by selling Treasury notes. That not only increases the supply of money, it also increases the debt and both will send the dollar's value down.

The third government tool is expansionary fiscal policies. They weaken the dollar by increasing the money supply. But these policies can also improve economic growth. That often makes investors demand more dollars as a safe haven. It's like a vote of confidence in the economy.

Sometimes this demand is so high that investors overlook the low interest rate they are getting by investing in dollars or U.S. Treasurys. The demand is even greater than the expansion in the supply of dollars.

Exchange rates, Treasury notes, and foreign exchange reserves offer three ways to measure the value of the dollar. Although the government is powerful in influencing exchange rates, it is still forex trading that actually changes them.

The chart below shows the Trade Weighted U.S. Treasury Index from 2000 through today.

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