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 Dollar equals the world supply for Euro. 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 one exchange rate that attracts 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 work 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 an example of the 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 as the Euro zone also trades intensively with countries that had relative high inflation rates (e.g. some countries in Central and Eastern Europe, Turkey, etc.), it is more important to collapse nominal exchange rate measures by relative price and cost developments

Fall of the Dollar

The significant (though steady and orderly) collapse of the Dollar from early 2002 to early 2004 against the Euro, Australian Dollar, Canadian Dollar and a few other currencies, its trade-weighted average, which is what counts for purposes of trade adjustment, has only fallen by 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 of the monetary authorities in Asia to keep their currencies weak will probably not work.

Various factors affect these, 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 of the currency, as more and more divisions 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 ruling party. For example, political or financial instability in Russia is also a flag for euro to US dollar exchange because of the substantial amount of Germany investment directed to Russia.

Economic Data:
Economic data items like labor report (payrolls, unemployment rate and average hourly earnings), Consumer Price Indexes (CPI), Producer Price Index (PPI), Gross Domestic Product (GDP), international trade, productivity, industrial production, consumer confidence etc., also affect the currency exchange rate fluctuations.

Confidence in a currency is the greatest determinant of the real Euro-Dollar exchange rate. Decisions are made keeping in mind the 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 the government's behalf) intervenes in the currency market so that the exchange rate stays close to an exchange rate target with a commitment to a single-fixed exchange rate and fluctuations from the central rate are not permitted.

Semi-Fixed Exchange Rates
Currency can move between permitted bands of fluctuation such that 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
Value of the currency is determined solely by market demand for and supply of the currency 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 country governments. 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 market supply of a currency cause a change in value. It is rare for pure free floating exchange rates to exist - 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.
Advantages of Fixed Exchange Rates are disadvantages of floating rates:
Fixed rates provide greater certainty for exporters and importers and under normally 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.