This article provides an overview of the factors affecting the leading currency pair: euro-dollar exchange commonly referred to as EUR/USD.
The euro-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 the Euro Dollar 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, precious metals and other commodities
- The relative fiscal position
The nominal bilateral dollar to euro currency exchange is the exchange rate that attracts the most attention. Despite 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 term, 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 correlations between the bilateral dollar to euro exchange rate, and different measures of the effective exchange rate of Euroland, have 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 exchange 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 2007 against the euro, Australian dollar, Sterling Pound, Canadian dollar and a few other currencies (i.e., its trade-weighted average, which is what counts for purposes of trade adjustment), remains significant.
In the wake of the sub-prime mortgage crises in the US, dollar losses escalated and continued to feel the backlash. The Fed responded with several rounds of rate hikes while weighing the balance of domestic growth and inflation fears.
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 or indices 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.
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. 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.