The U.s. Dollar and The Euro: The Exchange Rate

An exchange rate “states the price, in terms of one currency, at which another currency can be bought.” In summary, an exchange rate indicates “some way to convert one currency to another” (Baumol and Blinder 378). The U.S. dollar and the euro are the top two currencies in the world. It is critical to note that both currencies have a floating exchange rate; specifically, exchange rates are determined by the market and therefore determined by the law of supply and demand (379). The demand for the opposite currency is where the exchange rate comes from, and the fluctuation of the exchange rate is where it goes. The determinants of the exchange rate between the euro and the U.S. dollar are a topic of much debate and many differing conclusions. The main driving source of the U.S. dollar – euro exchange rate fits broadly into the category of international trade. From there, many factors influence where the exchange rate goes and how it fluctuates, but almost all sources agree upon two significant factors: productivity and the real price of oil.

The demand within international trade is the primary origin of the exchange rate, and the subsequent supply through this trade sways how the exchange rate stands at any given point in time. Looking at demand, there are many reasons why one country or group of countries might have desire to purchase a separate currency. Baumol and Blinder segment these demands into three main categories; specifically, international trade of goods and services, purchases of physical assets overseas, and international trade in financial instruments (380). For example, Baumol and Blinder explain the demand for the euro when purchasing international goods: “If Jane Doe, and American, wants to buy a new BMW, she will first have to buy euros with which to pay the car dealer in Munich. Thus, Jane’s demand for a European car leads to a demand for European currency”; summing up this point, they write, “In general, demand for a country’s exports leads to demand for its currency” (380). In explaining the concept of purchasing physical assets overseas, Baumol and Blinder employ an example with IBM: “If IBM wants to buy a small Irish computer manufacturer, the owners no doubt want to receive euros. So IBM will first have to acquire European currency” (380). Overall, they claim that “direct foreign investment leads to demand for a country’s currency” (380). Finally, as an example of demand for international trade in financial instruments, Baumol and Blinder illustrate, “If American investors want to purchase French stocks, they will first have to acquire the euros that the sellers will insist on for payment. In this way, demand for European financial assets leads to demand for European currency… Thus, demand for a country’s financial assets leads to demand for its currency” (380). As exemplified by Baumol and Blinder, the international trade demands of a country are the primary source of the exchange rate. In the supply-demand dichotomy, the supply can be found by reversing the above transactions; if a country wishes to sell their goods, physical assets, or financial instruments, they must be willing to supply and sell their currency to foster this trade. Baumol and Blinder note that “The supply of a country’s currency arises from its imports, and from foreign investment by its own citizens” (380). Beyond these subjects, one must examinine what causes the exchange rate to fluctuate as it does; in short, where does the exchange rate go?

One of the important influences on the exchange rate between the U.S. dollar and euro is productivity -- as supported by Alquist’s claim, “Economy-wide productivity differentials… appear to have a strong impact on the dollar/euro rate” (5). Productivity differentials are simply the difference between the productivity of two nations or economic groups; here in this situation, there is always some amount of differential between the productivity found in the European Union and the United States. This is a source for the adjusting exchange rate in an intuitive supply-demand fashion. As one group produces more goods for international trade and domestic consumption, the value of the currency needed to purchase these goods increases, as mentioned above in the section regarding international trade. For example, if the U.S. shows higher productivity, the demand for the U.S. dollar increases. What is perhaps most interesting amount this source of the exchange rate is the difficultly in explaining the magnitude of its effect. This differential has a multiplicative divergent effect on the exchange rates; as Alquist finds, “a one perecentage point increase in U.S.-euro area productivity differential results in a 4.4 percent appreciation” (5). While Alquist does not illustrate a comprehensive model which explains the power of the productivity differential, he does state that it can be partially explained by assuming that spending falls disproportionately on domestic goods (Alquist 18). Clearly, the productivity differential is a noteworthy part of what influences where the exchange rate goes.

The last prominent influence on the exchange rate between the U.S. dollar and the euro is the real price of oil. Oil, being arguably the most valuable commodity available, has a high impact on both the U.S. and the European Union as its price fluctuates. Understandably, the price of oil will, as Clostermann and Schnatz describe, “improve the international competitiveness of those countries which are relatively less dependent on oil imports (or which actually export oil)” (8). As oil prices increase, countries which are more resilient to these increased prices -- based on their lowered dependence -- will economically see less loss. This will improve the relative standing of that country’s currency. Clostermann and Schnatz argue, “an oil price increase should therefore result in a real appreciation of the currency of the country less dependent upon oil” (8). Then, the question to consider is, “Who is less dependent on oil between the United States and the European Union?” Clostermann and Schnatz claim, “Although the United States consumes more oil relative to its economic activity than the euro area countries, the United States is at the same time more self-sufficient in oil whereas the euro area countries are almost entirely dependent on imports of oil to meet their needs. Consequently, a permanent rise in real world oil prices should result in a real depreciation of the synthetic euro” (8). This position is somewhat debated, as Alquist claims that oil does not have an immediate appreciable effect on the exchange rate; however, Clostermann and Schnatz point out that the effects of oil price changes are slow to appear and often lag behind the price change. As such, it is to attribute the exchange rate alteration to the oil price change, but Clostermann and Schnatz provide relevant data to suggest that this causation is plausible. “Since oil price changes lead only slowly into real exchange rate adjustments, these effects are still felt in the following quarters,” describe Clostermann and Schnatz (19). That being said, it would make sense that such a dominating economic product would make some sort of non-negligible impact upon the economies of the European Union and the U.S.; furthermore, with the difference in oil dependencies between these groups, it would also seem logical to believe that these oil changes can, in fact, change where the exchange rate will go.

Although the determinants of the U.S. dollar to euro exchange rate are a divisive topic, it is fair to conclude that the main driving source of the given exchange rate fits broadly into the category of international trade, and almost all sources agree upon the two additional and significant factors of productivity and the real price of oil. As one can almost always conclude regarding topics within economics, the U.S. dollar – euro exchange rate’s origin and direction are both ultimately driven by the law of supply and demand, and the determinants fit within this overarching law.