This paper will discuss the general relationship between the two major currencies of the world: the US-Dollar and the Euro and the determinants for the exchange rate fluctuations
since the introduction of the Euro as the common currency of Europe during the period
between January 1999 and November 2005. Since the introduction of the Euro as the common
currency of the European Monetary Union (EMU) in 1999 this relationship was first
characterized by a sharp depreciation of the Euro followed by a three year lasting appreciation
of the same that passed over in a slight depreciation again from the beginning of 2005 in the
long run.1 This paper will first focus on the History of the international currency exchange
system from the 19th century until the end of the Bretton Woods System in 1973 and on the
history of the currency system in the European community. It will then discuss the general
determinants of exchange rates in the short and long run. It will be pointed out that in the
short run interest rate differentials and expectations of international portfolio investors matter
and in the long run the economic fundamentals such as inflation rates and GDP growth rates
of either economic region are the main factors for the behaviour of the exchange rate. In this
context the theories of the Law of one price and the purchasing power parity are introduced.
In the third part of the paper the exchange rate theories introduced in the previous part are
applied to the €-$ exchange rate in the time period between 1999 and 2005. Thus, the short
term and long term factors are used to explain the relationship between the two currencies in
this period. Finally, the last part serves as a conclusion.
Table of Contents
1. Introduction
1.1 The History of the International Currency Exchange System
1.2 The History of the Euro as the Common Currency of Europe
2. General Determinants of Exchange Rates in the Short and Long Run
2.1 The Short Run – The Role of Interest Rate Differentials and Market Expectations
2.2 The Long Run – Purchasing Power Parity (PPP)
2.2.1 Purchasing Power Parity – Absolute and Relative
2.2.2 The Monetary Approach (Quantity Theory Equation)
3. The Relationship between the Euro and the US Dollar
3.1 The Short Run – Interest Rate Parity
3.2 The Long Run – Economic Fundamentals, Inflation Rates and Long Term Trends
3.3 The US ’Twin Deficit’ and the Chinese Role in the €-$ Relationship
4. Conclusion
Research Objectives and Core Themes
This paper examines the fundamental relationship between the US-Dollar and the Euro, analyzing the primary determinants of exchange rate fluctuations between 1999 and 2005 through both short-term market dynamics and long-term economic indicators.
- The influence of interest rate differentials and market expectations on short-term exchange rate volatility.
- Application of Purchasing Power Parity (PPP) and the monetary approach to explain long-term trends.
- The impact of macroeconomic fundamentals, including inflation rates and GDP growth, on currency valuation.
- An investigation into the US "Twin Deficit" and the role of international central bank interventions in shaping the Euro-Dollar relationship.
Excerpt from the Book
2.2.2 The Monetary Approach (Quantity Theory Equation)
In the long run, the money supply and its growth rate actually determines the national price level or the inflation rate of an economy. So relative money supplies are closely related to exchange rates and affect them in the long run. To understand this relationship, the quantity theory equation must be applied. It assumes that in every country the money supply must be equal to the money demand which can be seen as the money value of the country’s GDP9. As it is know from the absolute PPP, e = P/Pf so that the exchange rate e between one currency and another is determined by the difference in the money supplies and the difference in the real output between the two countries. The value of one currency will appreciate when the country has a relatively slower money supply growth or a relatively faster growth in real output and vice versa.
Concerning this equation, e rises by 1 percent for 1) a one percent increase in the domestic money supply 2) a one percent decrease in the foreign money supply 3) a one percent decrease in domestic real GDP or 4) a one percent rise in foreign GDP. When a country has a comparable higher real output or income caused by a supply-side reason such as an increase in productivity and the prices remain constant, the ability to produce more leads to the ability to export more (higher supply – lower prices) so that the value of its currency appreciate.
Chapter Summaries
1. Introduction: Outlines the historical context of the Euro-Dollar relationship and defines the research scope concerning short-term fluctuations and long-term economic determinants.
2. General Determinants of Exchange Rates in the Short and Long Run: Establishes theoretical foundations, differentiating between asset market approaches for the short run and macroeconomic fundamentals for the long run.
3. The Relationship between the Euro and the US Dollar: Applies theoretical models to the specific historical data of the Euro-Dollar pair, focusing on interest rate parity and inflation differentials.
4. Conclusion: Synthesizes findings, emphasizing the critical role of inflation expectations and monetary policy in determining long-term exchange rate trends.
Keywords
Exchange Rate, Euro, US-Dollar, Interest Rate Parity, Purchasing Power Parity, Inflation Rate, Monetary Policy, Twin Deficit, European Monetary Union, Asset Market Approach, Quantity Theory of Money, Currency Appreciation, Currency Depreciation, GDP Growth, Central Bank
Frequently Asked Questions
What is the primary focus of this paper?
The paper explores the drivers behind exchange rate fluctuations between the Euro and the US-Dollar during the 1999–2005 period.
What are the central themes discussed?
The text balances short-term market dynamics, such as interest rate differentials, with long-term macroeconomic fundamentals like inflation and GDP growth.
What is the main research objective?
The objective is to apply standard economic exchange rate theories to the actual market behavior of the Euro-Dollar pair observed in the six years following the Euro's introduction.
Which scientific methods are employed?
The study utilizes a comparative analytical approach, evaluating theoretical frameworks (PPP, Monetary Approach, Interest Rate Parity) against historical interest rate, inflation, and fiscal data.
What does the main body cover?
It covers the history of currency systems, the theoretical determinants of exchange rates, and a detailed application of these theories to the specific relationship between the US and the Eurozone.
Which keywords characterize this work?
Key terms include Exchange Rate, Purchasing Power Parity, Interest Rate Parity, Monetary Policy, and the US Twin Deficit.
How does the "Twin Deficit" impact the exchange rate?
The paper discusses how market concerns regarding the US fiscal and current account deficits can shift investor confidence, contributing to the depreciation of the US-Dollar.
What role do central banks play according to the author?
Central banks influence exchange rates through monetary policy; by adjusting interest rates and controlling the money supply, they manage inflation, which ultimately signals to global markets the future value of the currency.
- Quote paper
- Ralph Johann (Author), 2005, Determinants of an exchange rate, Munich, GRIN Verlag, https://www.grin.com/document/114407
