Euro-US Dollar exchange rate

Euro-US Dollar exchange rate Ilari Lampela Markus Krüger Caroline Pfaffmann Contents • • • – – – – Introduction History of Euro Factors affecting the exchange rate Interest rates Inflation Trade flows Iraq and Afghanistan wars • – – Historical devellopment Euro- USD Different phases The signifigance of different factors during the phases • Recent events affecting the exchange rate History of the Euro • 1952 – European Coal and Steel Community (ECSC) • 1962 – First idea of an economic and monetary union • 1979 – European Currency System • 1990 – Members open market for free capital trade • 1992 – Maastricht Treaty • 1994 – European Monetary Institute • 1999 – Euro introduced Interest rate & Exchange rate I 1. Central bank lowers the lending rate, which increases the supply 2. The market’s interest rate lowers Interest rate & The aggregate supply and demand I The whole economy's supply and demand AS AD'' AD' AD Lowered interest rate boosts the economy, which increases the aggregate demand AD --> AD’ General price level Real GDP Interest rates & Exchange rate II 3. & 4. Because of lowered interest rate the investments to the area become less attractive. The result of this is an increased supply and decreased demand in the currency markets. 5. The currency depreciates Interest rate & The aggregate supply and demand II The whole economy's supply and demand AS AD'' AD' AD Real GDP Lower exchange rate boosts exports, which increases even more the aggregate demand AD’ --> AD’’ General price level Inflation & Exchange rate • Inflation in theoretical view has quite straightforward effects on the exchange rate of a currency • The currency with the higher inflation will depreciate against the currency with a lower inflation Trade Flow Influences Trade deficit: IM > EX => S exchange rate shift from S‘ to S, D‘ to D Trade surplus: EX > IM => S exchange rate shift from S to S‘, D to D‘ Trade Flow Influences Effects of the Iraq & Afghanistan War The development of the EUR-USD exchange rate Exchange rate 1€ =… $ 4. 3. 2. 1. Different phases of EUR-USD exchange rate development Phase 1 (Jan 99 – Jun 01) – increasing dollar value • Interest rates – FED’s rate > ECB’s rate, difference about 2% – FED started lowering sharply the lending rate in the beginning of 2001, rates same in March 2001 • Trade balance – Slowly increasing negative balance, -$400 billion the highest deficit • Inflation – Inflation percentages the same until year 2001, when USA’s inflation dropped significantly The development of the EUR-USD exchange rate Exchange rate 1€ =… $ 4. 3. 2. 1. Different phases of EUR-USD exchange rate development Phase 2 (Jun 01– Jan 05) - decreasing dollar value • Interest rates – ECB’s rate > FED’s rate, difference about 1% – FED lending rate increases start in middle of 2004, rates same in November 2004 • Trade balance – Fastly increasing negative balance, -$750 billion the highest deficit • Inflation – Increasing inflation in the USA – USA inflation < Euro inflation until 2003, after other way around • Other factors – 9/11/2001 – Afghanistan war began in October 2001 – Iraq war began in March 2003 The development of the EUR-USD exchange rate Exchange rate 1€ =… $ 4. 3. 2. 1. Different phases of EUR-USD exchange rate development Phase 3 (Jan 05 – Jan 06) - increasing dollar value • Interest rates – FED’s rate > ECB’s rate, difference about 1,5% • Trade balance – Negative balance of $750 billion • Inflation – Higher inflation in the USA than in Europe • Other factors – Continuing wars The development of the EUR-USD exchange rate Exchange rate 1€ =… $ 4. 3. 2. 1. Different phases of EUR-USD exchange rate development Phase 4 (Jan 06 -->) - decreasing dollar value • Interest rates – FED’s rate > ECB’s rate until middle of 2007 – In the end of 2007 FED sharply cuts its lending rate • Trade balance – Steady negative balance of $800 billion • Inflation – US inflation 0,5% higher than the Euro inflation • Other factors – Continuing Iraq war – Finance crisis in autumn 2007 Observations • Until the beginning of the year 2006 differences in the interest rates correspond to the exchange rate development – New situation? • Trade deficits and inflations effects unclear – USA’s wars increased trade deficit and inflation? – Both should lower the exchange rate