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Dollar-euro currency exchange
This article provides an overview of the factors affecting the
leading currency pair: Euro-dollar exchange, commonly expressed
as EUR/USD.
The euro to dollar exchange rate is the price at which the
world demand for US dollars equals the world supply of euros.
Regardless of geographical origin, a rise in the world demand
for euros leads to an appreciation of the euro. |
Factors affecting exchange rates
Four factors are identified as fundamental determinants of the real
euro to dollar exchange rate:
The international real interest rate differential
Relative prices in the traded and non-traded goods sectors
The real oil price
The relative fiscal position
The nominal bilateral dollar to euro exchange is the exchange rate
that attracts the most attention. Notwithstanding the comparative
importance of euro to US dollar bilateral trade links, trade with
the UK is, to some extent, more important for the Euro zone than
is trade with the US. The dollar and the euro have a strong predisposition
to run together in the very short run, but sometimes there can be
significant discrepancies. The very strong appreciation of the dollar
against the euro in 2003 is one example of these discrepancies.
In the long run, the correlation between the bilateral dollar to
euro exchange rate, and different measures of the effective exchange
rate of Euroland, has been rather high, especially if one looks
at the effective real exchange rate. As inflation is at very similar
levels in the US and the Euro area, there is no need to adjust the
dollar to euro rate for inflation differentials, but because the
Euro zone also trades intensively with countries that have relatively
high inflation rates (e.g. some countries in Central and Eastern
Europe, Turkey, etc.), it is more important to downplay nominal
exchange rate measures by looking at relative price and cost developments.
The fall of the dollar
The steady and orderly decline of the dollar from early 2002 to
early 2004 against the euro, Australian dollar, Canadian dollar
and a few other currencies (i.e., its trade-weighted average, which
is what counts for purposes of trade adjustment), while significant,
has still only amounted to about 10 percent.
There are two reasons why concerns about a free fall of the dollar
should not be worth consideration. The first is that the US external
deficit will stay high only if US growth remains vigorous. But if
the US continues to grow strongly, it will also retain a strong
attraction for foreign capital, which should support the dollar.
The second reason is that the attempts by the monetary authorities
in Asia to keep their currencies weak will probably not work.
The basic theories underlying the dollar to euro exchange rate:
Law of One Price: In competitive markets free of transportation
cost barriers to trade, identical products sold in different countries
must sell at the same price when the prices are stated in terms
of the same currency.
Interest rate effects: If capital is allowed to flow freely, exchange
rates become stable at a point where equality of interest is established.
The dual forces of supply and demand determine euro vs. dollar
exchange rates. Various factors affect these two forces, which in
turn affect the exchange rates:
The business environment: Positive indications (in terms of government
policy, competitive advantages, market size, etc.) increase the
demand for the currency, as more and more enterprises want to invest
there.
Stock market: The major stock indices also have a correlation with
the currency rates.
Political factors: All exchange rates are susceptible to political
instability and anticipations about the new government. For example,
political or financial instability in Russia is also a flag for
the euro to US dollar exchange because of the substantial amount
of German investments directed to Russia.
Economic data: Economic data such as labor reports (payrolls, unemployment
rate and average hourly earnings), consumer price indices (CPI),
producer price indices (PPI), gross domestic product (GDP), international
trade, productivity, industrial production, consumer confidence
etc., also affect fluctuations in currency exchange rates.
Confidence in a currency is the greatest determinant of the real
euro-dollar exchange rate. Decisions are made based on expected
future developments that may affect the currency. A EUR/USD exchange
can operate under one of four main types of exchange rate systems:
Fully fixed exchange rates
In a fixed exchange rate system, the government (or the central
bank acting on its behalf) intervenes in the currency market in
order to keep the exchange rate close to a fixed target. It is committed
to a single fixed exchange rate and does not allow major fluctuations
from this central rate.
Semi-fixed exchange rates
Currency can move inside permitted ranges of fluctuation. The exchange
rate is the dominant target of economic policy-making, interest
rates are set to meet the target and the exchange rate is given
a specific target.
Free floating
The value of the currency is determined solely by market supply
and demand forces in the foreign exchange market. Trade flows and
capital flows are the main factors affecting the exchange rate.
A floating exchange rate system: Monetary system in which exchange
rates are allowed to move due to market forces without intervention
by national governments. For example, the Bank of England does not
actively intervene in the currency markets to achieve a desired
exchange rate level. With floating exchange rates, changes in market
demand and supply cause a currency to change in value. Pure free
floating exchange rates are rare - most governments at one time
or another seek to "manage" the value of their currency
through changes in interest rates and other controls.
Managed floating exchange rates
Governments normally engage in managed floating if not part of a
fixed exchange rate system.
The advantages of fixed exchange rates are the disadvantages of
floating rates:
Fixed rates provide greater certainty for exporters and importers
and, under normal circumstances, there is less speculative activity
- although this depends on whether the dealers in the foreign exchange
markets regard a given fixed exchange rate as appropriate and credible.
Advantages of floating exchange rates
Fluctuations in the exchange rate can provide an automatic adjustment
for countries with a large balance of payments deficit. A second
key advantage of floating exchange rates is that it gives the government/monetary
authorities flexibility in determining interest rates.
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