The steady and orderly decline of the US 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 20 percent.
There are two reasons why concerns about a free fall of the US dollar may not
be worth considering. Firstly, the US external deficit will stay high only if US
growth remains vigorous, and if the US continues to grow strongly, it will also
retain a strong attraction for foreign capital which, in turn, should support
the US dollar. Secondly, attempts by the monetary authorities in Asia to keep
their currencies weak will probably not work in the long run.
The basic theories underlying the US 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
These two reciprocal forces determine euro vs. US 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 in its place of
origin.
Stock market: The major stock indices also have a correlation with the
currency rates, providing a daily read of the mood of the business
environment.
Political factors: All exchange rates are susceptible to political instability and
anticipation about new governments. For example, political instability in
Russia is also a flag for the euro to US dollar exchange, because of the
substantial amount of German investment in 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
currency exchange rates.
Confidence in a currency is the greatest determinant of the real euro to US
dollar exchange rate. Decisions are made based on expected future
developments that may affect the currency.
