INTRODUCTION The Gold Standard
As global trade has grown, so has the need for international institutions to maintain stable, or at least predictable, exchange rates. But the nature of that challenge and the strategies required to meet it evolved considerably since the end of the World War II -- and they were continuing to change even as the 20th century drew to a close. Before World War I, the world economy operated on a gold standard, meaning that each nation's currency was convertible into gold at a specified rate. This system resulted in fixed exchange rates -- that is, each nation's currency could be exchanged for each other nation's currency at specified, unchanging rates. Fixed exchange rates encouraged world trade by eliminating uncertainties associated with fluctuating rates, but the system had at least two disadvantages. First, under the gold standard, countries could not control their own money supplies; rather, each country's money supply was determined by the flow of gold used to settle its accounts with other countries. Second, monetary policy in all countries was strongly influenced by the pace of gold production. In the 1870s and 1880s, when gold production was low, the money supply throughout the world expanded too slowly to keep pace with economic growth; the result was deflation, or falling prices. Later, gold discoveries in Alaska and South Africa in the 1890s caused money supplies to increase rapidly; this set off inflation, or rising prices. The gold standard collapsed in the wake of World War I. Wartime financing with un backed paper currency led to widespread inflation. European nations tried to resume the gold standard in the 1920s, but the gold supply was insufficient and inelastic. A ferocious monetary squeeze and competition across countries for limited gold reserves followed and contributed to the Great Depression. After World War II, nations adopted the dollar-exchange standard. The U.S. dollar was backed by gold at $35 per ounce, while the rest of the world’s currencies were backed by dollars. The global money stock could expand through dollar reserves.

Nations attempted to revive the gold standard following World War I, but it collapsed entirely during the Great Depression of the 1930s. Some economists said adherence to the gold standard had prevented monetary authorities from expanding the money supply rapidly enough to revive economic activity. In any event, representatives of most of the world's leading nations met at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system. Because the United States at the time accounted for over half of the world's manufacturing capacity and held most of the world's gold, the leaders decided to tie world currencies to the dollar, which, in turn, they agreed should be convertible into gold at $35 per ounce. Under the Bretton Woods system, central banks of countries other than the United States were given the task of maintaining fixed exchange rates between their currencies and the dollar. They 2

[1] These goals usually include stable prices and low unemployment. often targeting a rate of interest to attain a set of objectives oriented towards the growth and stability of the economy. Where currency is under a monopoly of issuance. Conversely. but the effort failed. and the total supply of money. if the value of a country's money was too low. exchange rates with other currencies and unemployment. MONETARY POLICY Monetary policy is the process by which the monetary authority of a country controls the supply of money. Eventually. But those nations were reluctant to take that step. Economists call the resulting system a "managed float regime. Americans urged Germany and Japan. especially for countries with large trade deficits. Monetary policy uses a variety of tools to control one or both of these. By that time. Monetary theory provides insight into how to craft optimal monetary policy. the United States abandoned the fixed value of the dollar and allowed it to "float" -. If a country's currency was too high relative to the dollar. countries with large trade surpluses often sell their own currencies in an effort to prevent them from appreciating (and thereby hurting exports). the country would buy its own currency. to appreciate their currencies. both of which had favorable payments balances. But there are limits to what can be accomplished through intervention. or a contractionary policy. a country that intervenes to support its currency may deplete its international reserves. the price at which money can be borrowed. to influence outcomes like economic growth. Monetary policy is referred to as either being an expansionary policy. Monetary policy is contrasted with fiscal policy. By 1973. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates. its central bank would sell its currency in exchange for dollars.did this by intervening in foreign exchange markets. to fluctuate against other currencies. or where there is a regulated system of issuing currency through banks which are tied to a central bank. Finally. that is. making it unable to continue buttressing the currency and potentially leaving it unable to meet its international obligations. which refers to government borrowing.that is. thereby driving up the price. since raising the value of their currencies would increases prices for their goods and hurt their exports. As in 1971. spending and taxation Monetary policy rests on the relationship between the rates of interest in an economy. World leaders sought to revive the Bretton Woods system with the so-called Smithsonian Agreement in 1971. driving down the value of its currency. The dollar promptly fell. the United States and other nations agreed to allow exchange rates to float." meaning that even though exchange rates for most currencies float. countries with large deficits often buy their own currencies in order to prevent depreciation. and a contractionary policy decreases the total money supply. inflation. the monetary authority has the ability to alter the money supply 3 . where an expansionary policy increases the total supply of money in the economy rapidly. The Bretton Woods system lasted until 1971. or increases it slowly. which raises domestic prices. By the same token. central banks still intervene to prevent sharp changes. inflation in the United States and a growing American trade deficit were undermining the value of the dollar. while contractionary policy involves raising interest rates to combat inflation.

The beginning of monetary policy as such comes from the late 19th century. with the exception of weekends. and increasing reserve requirements. such as treasury bills.[2] 4 . There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat. It also supports speculation. the short term goal of open market operations is to achieve a specific short term interest rate target. special institutions (such as the Federal Reserve System in the United States. company bonds. All of these purchases or sales result in more or less base currency entering or leaving market circulation. or if it raises the interest rate. or decreases the interest rate. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments.and thus influence the interest rate (to achieve policy goals). FX. All have the effect of contracting the money supply. The foreign exchange market determines the relative values of different currencies. FOREIGN EXCHANGE MARKET: The foreign exchange market (forex. in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies. neutral. the Bank of England. Since the 1970s. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly. In general. the European Central Bank. monetary policies are described as follows: accommodative. the Bretton Woods system still ensured that most nations would form the two policies separately. the People's Bank of China. and the Bank of Japan) exist which have the task of executing the monetary policy and often independently of the executive. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock. expand the money supply. Even prior to the 1970s. Within almost all modern nations. by allowing businesses to convert one currency to another currency. if it is intended neither to create growth nor combat inflation. monetary policy has generally been formed separately from fiscal policy. or currency market) is a worldwide decentralized overthe-counter financial market for the trading of currencies. Usually. even though the business's income is in US dollars. it permits a US business to import British goods and pay Pound Sterling. The primary tool of monetary policy is open market operations. In other instances.[1] The primary purpose of the foreign exchange is to assist international trade and investment. For example. or tight if intended to reduce inflation. reducing the monetary base. if reversed. Furthermore. and. or foreign currencies. and facilitates the carry trade. An expansionary policy increases the size of the money supply more rapidly. these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system. if the interest rate set by the central monetary authority is intended to create economic growth. where it was used to maintain the gold standard. monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. and which (it has been claimed) may lead to loss of competitiveness in some countries.

Canadian Dollar. as opposed to the futures contracts. EURO and Russian Ruble. Usually the date is decided by both parties. The average contract length is roughly 3 months. FUTURE Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example. money does not actually change hands until some agreed upon future date. involves cash rather than a contract. a party purchases a quantity of one currency by paying a quantity of another currency. SPOT A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar. largest and most liquid market for options of any kind in the world. The duration of the trade can be one day. In this transaction. $1000 for next November at an agreed rate [4].[5]. which settle the next business day). and interest is not included in the agreed-upon transaction.. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime.In a typical foreign exchange transaction. FORWARD One way to deal with the foreign exchange risk is to engage in a forward transaction. and the transaction occurs on that date. and forward contract is a negotiated and agreement between two parties SWAP The most common type of forward transaction is the currency swap. These are not standardized contracts and are not traded through an exchange. Turkish Lira. which are usually three months. which remained fixed as per the Bretton Woods system. A buyer and seller agree on an exchange rate for any date in the future. a few days. 5 . regardless of what the market rates are then. In a swap. OPTION A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. has the shortest time frame. Futures are standardized and are usually traded on an exchange created for this purpose. Futures contracts are usually inclusive of any interest amounts. two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. The FX options market is the deepest. months or years. This trade represents a “direct exchange” between two currencies.

The Federal Reserve Act of 1913 created one central bank and organised a national banking system that could keep up with the changing financial needs of the country. This process of incorporating the currency of one country into a different economic market is called 'dollarization'. Various British imposed restrictions on the colonial paper currencies were in place until being outlawed. the currency did not last long as there was insufficient financial backing and the notes were easily counterfeited. the Continental Congress introduced the Continental currency. when the colonists were preparing to go to war with the British. The designs of the notes would not be changed again until 1996 when a series of improvements were carried out over a ten-year period to prevent counterfeiting. Palau.US Dollar US dollar’s history The currency of the United States can be traced back to 1690 before the birth of the country when the region was still a patchwork of colonies. Congress then chartered the first national bank in Philadelphia . and in some cases used as the official currency. Pitcairn Islands. Federated States of Micronesia. Paper notes or greenbacks were introduced into the system in 1861 to help finance the Civil War. silver. The same designs were also printed on all dominations instead of individual designs. However. the other colonies quickly followed. The Federal Reserve Board created a new currency called the Federal Reserve Note. 6 . Participating Members The United States Dollar has been adopted. In 1775. and copper. The Coinage Act of 1792 helped put together an organised monetary system that introduced coinage in gold. The Massachusetts Bay Colony used paper notes to finance military help with the government's finances. This gave national banks the power to distribute money and to purchase US bonds more easily whilst still being regulated. Finally. Congress put together the national banking system that granted the US Treasury permission to oversee the issuance of National Bank notes. Ecuador. and Turks and Caicos Islands.the Bank of North America . In 1863. East Timor. Marshall Islands. Dollarization of the US Dollar has occurred in the British Virgin Islands. a decision by the Federal Reserve board was made to lower the manufacturing costs of the currency by reducing the actual size of the notes by 30%. The first federal note was issued in the form of a ten dollar bill in 1914. El Salvador. Panama. The dollar was chosen to become the monetary unit for the USA in 1785. in many different territories and countries. After the introduction of paper currency in Massachusetts. The paper notes used several different techniques including a Treasury seal and engraved signatures to help diminish counterfeiting.

77 to $2. Since March 2009.S. Treasury Dept. dollar holdings decreased from $2. Between Q1 2008 and Q2 2009 (most recent report). As creditor nations realize this. as investors sought a relatively safe haven.) Partly as a result of this deficit. COFER Table) 7 . debt. the dollar has resumed its decline. DOLLAR’S DECLINE In 2008. A weaker dollar means that the deficit will not cost the government as much to pay back. investments.S. government is not supporting the value of dollar. (Source: IMF. while increasing inflation. the value of euros held in foreign government reserves increased from $393 billion to $1.S. they have been gradually changing their assets to other currencies to stem their losses. however. The dollar strengthened during the recession.68 trillion in reserves. During this same time period. This is a result of the $11 trillion U. The euro could replace the dollar as an international currency. the current account deficit was $700 billion. DOLLAR DECLINE AND RISE OF EURO U.S.17 trillion. Over half of the current account deficit is owed to foreign countries and hedge funds.U.S. Many fear that this could turn into a run on the dollar. (Source: U.S. the dollar declined 40% between 2002-2008. This would quickly erode the value of U. Creditor nations believe that the U.

Abu Dhabi. But it is China's extraordinary new financial power – along with past anger among oil-producing and oil-consuming nations at America's power to interfere in the international financial system – which has prompted the latest discussions involving the Gulf states. Japan is the second largest investor. "One of the legacies of this crisis may be a recognition of changed economic power relations. It is facing pressure to lower its debt burden. the euro. Iran and Venezuela have both proposed oil-trading markets denominated in euros instead of dollars. The Britains are stuck in the middle and will come into the euro. Oil-exporting countries (and the Caribbean banking centers that often serve as their front) hold $356 billion. If they decide to trade oil in euros instead of dollars. For example. In the most profound financial change in recent Middle East history. Russia. in more recent years. gold and a new. for example. Japan and France – to end dollar dealings for oil. including Saudi Arabia. The decline of American economic power linked to the current global recession was implicitly acknowledged by the World Bank president Robert Zoellick. As of September 2009.China is the largest investor in dollars. the hegemony of the dollar as the dominant global reserve currency. it held nearly $800 billion in U. Japan and Brazil to work on the scheme. moving instead to a basket of currencies including the Japanese yen and Chinese yuan. The Chinese believe. which will mean that oil will no longer be priced in dollars. The Russians will eventually bring in the rouble to the basket of currencies. It has hinted it will reduce its holdings if the U. It buys Treasuries to keep the value of the yen low. 8 . Gulf Arabs are planning – along with China." he said in Istanbul ahead of meetings of the IMF and World Bank. China. However. Treasury Securities. that the Americans persuaded Britain to stay out of the euro in order to prevent an earlier move away from the dollar. Ever since the Bretton Woods agreements – the accords after the Second World War which bequeathed the architecture for the modern international financial system – America's trading partners have been left to cope with the impact of Washington's control and. so it can export more cheaply. They have no choice because they won't be able to use the US dollar. But Chinese banking sources say their discussions have gone too far to be blocked now. they would have less of a need to hold dollars to keep its value relatively higher. with $752 billion in holdings. and increase its debt. causing it to sell dollars. Secret meetings have already been held by finance ministers and central bank governors in Russia.S. Kuwait and Qatar.S. its debt is now 200% of its GDP. continues to spend on the stimulus package. unified currency planned for nations in the Gulf Co-operation Council.

Compared to 100 units at the start of the decade. but today only purchases 27. 2) The red line is the key.’s expansionary monetary policies in the Vietnam era). The proposal initially attracted attention mostly for its signal of China’s rising global economic power. but obviously with considerable volatility. gold anchored exchange rates and the physical supply of gold stabilized the money supply over the long term. which trends pretty much in the same direction as gold. This special role of the dollar in the international monetary system has contributed to the global scale of the financial crisis. Rethinking the Global Money Supply The People’s Bank of China jolted the financial world in March with a proposal for a new global monetary arrangement. President Richard Nixon delinked the dollar from gold in 1971 (to offset the U.S. The currency basket is the US Dollar Index. as did most foreign exchange reserves held by the world’s central banks. But most global trade and financial transactions remained dollar-denominated. 3) The black line shows the dollar’s purchasing power in terms of crude oil. the dollar now purchases only 32. Currencies were readily interchangeable. Easy money fed an unprecedented 9 . a 73% decline in the dollar’s purchasing power. A century ago almost all the world’s currencies were linked to gold and most of the rest to silver. and major currencies began to float against one another in value.1) The blue line shows how much less foreign currency the dollar can buy now. but its content also has much to commend it. though this is an improvement from the only 18 units the dollar purchased during the spike in crude oil prices in mid-2008. The exchange rates of many currencies also remained tightly tied to the dollar. and the dollar buys only 75 units compared to 100 at the start of the decade. The dollar could purchase 100 units of gold at the start of the decade. which is rooted in a combination of overly expansionary monetary policies by the Federal Reserve and lax financial regulations.

The “special drawing rights” of the International Monetary Fund is such a basket of four currencies (the dollar. Italy. Euro – history The European Economic and Monetary Union is an agreement between participating European nations to share a single currency. net exports to Asia. The U.S. followed by a wave of loan defaults. money markets. Treasury Secretary Timothy Geithner initially described himself as open to exploring the idea. Cyprus and Malta. The euro should probably strengthen against the dollar but weaken against Asian currencies.S. however. although the Chinese rightly suggest that it should be rebased to reflect a broader range of them. On average. response to the Chinese proposal was revealing. Spain. pound. The Chinese proposal requires study but seems consistent with the long-term shift to a more balanced world economy in which the U. his candor quickly caused the dollar to weaken in value—which it needs to do for the good of the U.S. Geithner’s first reaction was right. There are currently 27 member-states of varying degrees of integration with the European Economic and Monetary Union. U. China has now proposed that the world move to a more symmetrical monetary system.S. first in the U. Ireland. The result was a temporary worldwide credit bubble. Finland. monetary policy would accordingly lose its excessive global influence over money supplies and credit conditions. Sixteen member states have adopted the euro: Austria. Germany. dollar would remain the world’s reserve currency for the foreseeable future. a rising role for the Chinese yuan. Portugal. banking losses and a dramatic tightening of bank lending.S. yen and euro). Denmark and Sweden.surge in bank credits. Slovakia.S. plays a monetary role more coequal with Europe and Asia. the Netherlands. 10 . money supply was thus matched by a surge in the money supplies of countries linked to the U. economy. and. as international banks funded themselves in the U. Greece. but the changes ahead are not under the sole control of the U. from 1 January 2009. France. the United Kingdom. Luxembourg.S. Slovenia. from 1 January 2008.S. We will probably move over time to a world of greater monetary cooperation within Asia. As bank loans flowed into other economies. dollar. the euro and a single economic policy with set conditions of fiscal responsibility. No change of global monetary system will happen abruptly. Three other member states. including China’s yuan.S.S. many foreign central banks intervened to maintain currency stability with the dollar. falling housing prices. and then elsewhere. the dollar should depreciate against Asian currencies to encourage more U. Belgium. in which nations peg their currencies to a representative basket of others rather than to the dollar alone. That weakening. The surge in the U.S. and greater symmetry in overall world monetary and financial relations. led Geithner to reverse himself within minutes by underscoring that the U.

Stage II At the December 1995 summit in Madrid. participating European countries can be integrated into three different economic stages. which would succeed the European Monetary System and the Exchange Rate Mechanism after the launch of the euro. shaping what would eventually be called the European Single Market. This reference value was established in an aggregated basket of all the participating currencies called the European Currency Unit. In the second stage of the European Economic and Monetary Union. where it must stay for at least two years before adopting the euro.have no immediate plans to adopt the euro. the European Council in Amsterdam agreed to the Stability and Growth Pact and set up the Exchange Rate Mechanism II. The criteria include four requirements. Germany successfully argued to change the name of the European Currency Unit to the “euro”. International trade in the Single Market could be hindered by exchange-rate risk – despite the relative stability introduced by Exchange Rate Mechanism – and the increased transaction costs that this brought. The creation of a single currency for the single market seemed a logical solution. Other member states are in various stages of euro adoption and are expected to join the Eurozone within the next ten years. which correspond to the historical stages of European Economic and Monetary Union development.25%) on either side of a reference value. which was weighted according to the size of the member states’ economies. Currently. Stage III For each state to adopt the new currency on 1 January 2002. It aimed to remove institutional and economic barriers between European Community member states and established the goal of a common European market. It created the Exchange Rate Mechanism under which the exchange rates of each member state’s currency was to be restricted to narrow fluctuations (+/-2. The second stage of European Economic and Monetary Union development can be correlated to a recently acceded member state entering the Exchange Rate Mechanism II. they had to meet the “Convergence Criteria“ set out by the Maastricht Treaty. In June of 1997. 11 . and thus the idea of a single currency was brought back to the fore. In the late 1980s. The so called “Madrid scenario” also set out a transition period between the introduction of the euro in accounting and later as a cash currency. the market of each member state grew closer to its neighbours. the European Monetary Institute was established as a forerunner of the European Central Bank. the European Monetary System was established to link European currencies and prevent large fluctuations between their respective values. The first stage of European Economic and Monetary Union development can be correlated to a current candidate country first meeting the Copenhagen Criteria and then joining the European Union. Stage I In 1979.

dollar. Euro – U. we will analyze the evolution of the exchange euro/dollar.S. dollar exchange rate Firstly. best-performing member states Inflation had to be below a reference value (within 3 years prices may not be higher than 1. not only for these two large economic areas.S. having joined the Exchange Rate Mechanism II and maintaining the Convergence Criteria for at least two years.• • • • Currencies has to stay within the bands set by the Exchange Rate Mechanism for at least two years Long-term interest rates could not be more than two percentage points higher than those of the three.5% of best performer) Government debt had to be below 60% of GDP (or moving towards this objective) and budget deficits below 3% The third stage of European Economic and Monetary Union development can be correlated to a member state that. joins the Eurozone. Short run 12 . the relationship between them is particularly important. dollar relationship It is a known fact that the euro and the U. but also for the world economy as the whole. Next. The volatility of the euro – U.S. As a basis for assesing the effect of the advent of the euro on both shorter and longer-term exchange rate volatility.S. we must distinguish between a shorter-run exchange rate volatility which is associated with moderate negative effects on trade volumes and large longer-term exchange rate movements which may have more serious macroeconomic consequences. we will compare the experience since the introduction of the euro with the 25 preceding years when individual euro area currencies were floating against the U. dollar share the role of the world’s key international money. Due to this fact.

1% short-term volatility of the actual euro during the five years from the beginning of 1999 up to 2003. On the other hand. whatever are the factors underlying short-run exchange rate volatility. The average short-run volatility of the synthetic euro across the entire pre-euro era is 3. This suggests that. 13 . it can also be argued that downswing (below $1.00 or $0.95) was overdone and was unhelpful from a broader macroeconomic perspective.0%. Long run There is a plausible explanation for at least an important part of the down and up swing in the euro/dollar exchange rate during the past 6 years. they are not completely constant over time.The short-run volatility of the (dollar exchange rate of the) synthetic euro varies somewhat across the five sub-periods of the pre-euro era. This is almost exactly the same as the 3. When the euro was introduced at the start of 1999 there was widespread (although not universal) sentiment among economic analysts that the euro would appreciate moderately against the dollar —reflecting the status of the new currency as a credible rival to the dollar. the short term volatility of the euro exchange rate has not significantly changed from the pre-euro era. To conclude.

There is not a firm basis at this stage to conclude with confidence either that the euro has now appreciated sufficiently against the dollar to make the requisite contribution to restoring a sustainable pattern of international payments positions or that substantially greater appreciation of the euro against the dollar is still needed for this purpose. The medium-term equilibrium level of the euro/dollar exchange rate was in the range $1. 14 . The implication is that substantial further dollar depreciation will be needed to help reduce the U. in turn. Other considerations point in opposite directions. On the other hand.S. On an absolute purchasing power parity basis.The majority of specialists believed that on a multilateral basis the new euro appeared to be neither significantly undervalued nor significantly overvalued. Much of this further dollar depreciation should presumably come against those currencies where there has so far been little or no real exchange rate adjustment. despite significantly stronger demand growth in the United States than in the euro area.35. tourists find that Europe is expensive and that America is cheap. the multilateral real exchange rate of the euro appeared to be broadly consistent with a modest current account surplus for the euro area. reflected the medium-term equilibrium excess of saving over investment for the euro area. Specifically. current account deficit has continued to widen despite significant dollar depreciation over the past 2 years. But there is no credible reason to believe that the euro has meaningfully overshot a reasonable long-term equilibrium value versus the dollar. Because inflation rates in the euro area and the United States have been quite similar over the first 6 years after the introduction of euro. That current account surplus. and some (not unreasonable) estimates suggest that this deficit is likely to continue to widen at presently prevailing exchange rates. current account deficit to sustainable proportions. In particular. differential movements in national price levels do not imply that the medium-term equilibrium exchange rate between the euro and the dollar should have changed very much.S.25– $1. The euro/dollar exchange rate is nowin that range. with the euro area economy operating reasonably close to potential. The euro has already appreciated a great deal from what was clearly a substantially undervalued rate. the U. the euro looks expensive and the dollar looks cheap. and there is evidence that the bilateral trade balance of the United States vis-a-vis the euro area has begun to improve.

Turkey. identical products sold in different countries must sell at the same price when the prices are stated in terms of the same currency. As inflation is at very similar levels in the US and the Euro area. The theories underlying the U. etc. there is no need to adjust the dollar to euro rate for inflation differentials. it is more important to downplay nominal exchange rate measures by looking at relative price and cost developments. 15 .S. but because the Euro zone also trades intensively with countries that have relatively high inflation rates (e. dollar – euro exchange rate The basic theories underlying the dollar to euro exchange rate are: Law of One Price: In competitive markets free of transportation cost barriers to trade.The factors influencing the exchange rate 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 exchange rate that attracts the most attention.g. but sometimes there can be significant discrepancies. The very strong appreciation of the dollar against the euro in 2003 is one example of these discrepancies. some countries in Central and Eastern Europe.). The dollar and the euro have a strong predisposition to run together in the very short run.

Each transaction on this type of market includes two different trades: the sale of one currency and the purchase of another currency. the Romanian leu. gross domestic product (GDP). dollar is the most traded currency of all. as more and more enterprises want to invest there. competitive advantages. market size. multinational corporations need to convert regularly local currency into yen and vice versa. The dual forces of supply and demand determine euro vs. such as the Japanese yen.) increase the demand for the currency. In the end. next. 16 .S. we will also analyse the relationship between euro and the Romanian national currency. -Economic data: Economic data such as labor reports (payrolls. the U. etc. Since the U. the British sterling pound and the Swiss franc. IMPACT ON OTHER CURRENCIES The currency markets are the largest financial markets in the world. which in turn affect the exchange rates: -The business environment: Positive indications (in terms of government policy. This is why. The two currencies involved in this transaction are known as a pair.S.S.S. Various factors affect these two forces. political or financial instability in Russia is also a flag for the euro to U. industrial production. the yen has become a popular currency and the pair U. dollar is the world’s reserve currency. producer price indices (PPI). dollar – Japanese yen is heavily traded on international currency markets. Because of the low interest rates in Japan. consumer confidence etc. U. For example.S. productivity. Japan is one of the most significant exporter and due to this quality. Banks. international trade. -Political factors: All exchange rates are susceptible to political instability and anticipations about the new government.Interest rate effects: If capital is allowed to flow freely.. also affect fluctuations in currency exchange rates. dollar exchange rates. dollar – Japanese yen The Japanese economy is one of the largest economies in the entire world. dollar exchange because of the substantial amount of German investments directed to Russia. we will analyse the trading relationships between the U.S. consumer price indices (CPI). dollar and some of the most knows and powerful currencies. The majority of transactions occur among popular currency pairs. unemployment rate and average hourly earnings). hedge funds and central banks are the main actors on this markets. -Stock market: The major stock indices also have a correlation with the currency rates. multinational corporations. exchange rates become stable at a point where equality of interest is established.

Hence. rising commodity prices can hurt the economy and cause the yen to weaken. traders choose the yen to make money. Since the British sterling pound is an important currency in the international financial markets. and systemically stronger levels for the Japanese yen.S. has a better performance than the U. Traders should pay careful attention to the future course of Japanese economic growth. the popularity of the Japanese yen depends on the state of the global financial markets. Before the World War I. the yen is not that much preffered. maintaining its own currency. If U. the United Kingdom has not adopted the euro.S. the economy has grown continuously.. and consequently. Japan has relied on innovative manufacturing techniques. Because Japan is dependent on imported oil and other natural resources. It has become a center for global finance. the United Kingdom was the powerful nation in the world. When determining the relationship between these two currencies. economic performance is stronger than the U. the United Kingdom entered a period of decline whereas the United States of America developed continuously. since the 1980s. If U. An eventual economic recovery might bring with it higher interest rates. These rates have increased the popularity of the Japanese yen. investors consider trading the pair U. Due to the period of slow economic growth of Japan.’s. However. the dollar will weaken against the pound. the country has regained its economic vitality. However. dollar – British sterling pound In contrast with the small dimensions of the country. U. an end to the popularity of the yen carry trade. the most important factor is the strength of the two countries’ economies. the British sterling pound. 17 .S. the economy of the United Kingdom is developed. When volatility increases and the number of opportunities declines. Japan’s export dependency can also prompt central bank intervention when the yen begins to strengthen. dollar pair is one of the most liquid in the currency market. its central bank has been forced to maintain interest rates at a low level. the dollar will strengthen against the pound.K. new technologies. As we have seen in the above chapters.S. Another aspect that should be closely observed is the dependence that Japan has upon imports and exports.S. The Japanese yen is the most traded currency in Asia and among the most traded currencies in the entire world.S.K. The British pound/U. Since the Second World War. the liquidity of the pair combined with the availability of trading instruments makes the British pound/U.Being a small country with limited resources. a high national savings rate and cooperation between the government and the private sector to overcome its disadvantages. When volatility is low and there are many opportunities available in global financial markets. However. dollar – British sterling pound. dollar an excellent choice for all types of currency traders. After the two world wars. the British pound was very important. the financial sector has become the most important part of the British economy.

politicians speak against joining the European Monetary Union and in support of keeping an independent currency regime. This crisis has created gaps between the member nations. In EU. debt ratio of less than 60% of GDP. As of June 2010. The recent Euro Sovereign Debt Crisis was due to the rising public debt in PIIGS (Portugal. so it generally has a higher demand than supply. the U. may choose to join the European Monetary Union. also known as Monetary Union or Optimal Currency Area. Economic Growth. The euro is the second largest reserve currency as well as the second most traded currency in the world after the U.One specific feature of trading the British pound is that there is often conjecture that the U. politicians are speaking in favor of joining the European Monetary Union. were to join the European Monetary Union.K. It is generally believed that if the U. Ireland.S.K. The U. the pound typically strengthens. Like Lebanon. dollar is the currency most used in international transactions and is one of the world's reserve currencies. Several countries use it as their official currency.K. FUTURE OF EURO N DOLLAR: The analysis of US Dollar and Euro currency is based on the economic and non-economic indicators. Greece and Spain) and Greece finally defaulting. Geo-Politics. the euro is the currency with the highest combined value of banknotes and coins in circulation in the world. Italy. Factors deciding the Future of Dollar and Euro: 1.S. There were some pre requisites like a budget deficit of less than 3% of their GDP. The EU has also liberalized its capital markets. with more than €800 billion in circulation. lower interest rates or print money so the option was only bailout which was opposed by Germany. Trade & Capital Flows and Merger & Acquisition Activity. in many others it is the de facto currency (unit of money that is not legal tender in a country but is treated as such by majority of the population). Iraq use US ($) and Andorra. Due to obvious reason PIIGS supported the bailout altogether.K. when U. so the demand is not limited to US only rather there are other countries mentioned above. dollar. there are 16 member nations out of 27 total members share euro as their common currency. trade theories applicable and various factors which are believed to drive Forex market like Interest Rates. 18 . Zimbabwe. One more factor that comes into play is de facto currency. and as the European Central Bank has chosen monetary autonomy. the pound typically depreciates. Kosovo use Euro (€). low inflation. Exchange Rate Mechanism: US follow a free float in which the movements are totally determined by the market. the exchange rate regime of the euro is floating. and interest rates have to be close to the EU average.S. The disadvantages with such system is they cannot devalue their currency. Therefore. would have to give up the pound and use only the euro. But many of the nations were allowed to follow euro without scrutinizing the above norms. dollar. when U. it would first need to devalue the pound.K. If this were to happen. having surpassed the U.

dollar is expected to appreciate in this regard as well. Geo politics: The currency market is the only market in the world that can be successfully traded on political news as well as economic releases. Regional Divergences are some other factors which make us ponder over the future of Euro. Because currencies represent countries rather than companies. Economic growth: Economic growth inspires higher interest rates inspires more foreign investment inspires greater currency demand which inspires an increase in the currency's value. Some countries are sensitive to trade flows. 2. 3.000 basis points from 1. Thus. the Euro zone is lagging significantly behind the United States in economic growth. If the focus is on growth.2271. 5. If the Interest Rate Parity condition holds true. The key to understanding speculative behavior with respect to any geopolitics is that whenever investors fear any threat to their capital. while the Euro Zone continue to post positive key economic data after quarter ending June. Hence. Consequently.3468 to 1. the average debt-to-GDP ratio hides very large differences between countries and the region doesn’t have a mechanism to deal with these differences. More foreign investors mean a greater demand for the country's currency. they will quickly retreat to the sidelines until they are certain that the political risk has disappeared. Capital flow refers to how much investment a country attracts from abroad. 4. shores. the greater the possibility that the central bank will raise its interest rates to tame the growth of inflation and the higher a country's interest rates. while others are far more dependent on capital flows. they are political as well as economic assets and are therefore very responsive to any of the disturbances. Therefore. Interest Rates: The stronger the economy. 1. A greater demand results in an increase in a currency's value. The United States and Euro zone represent two of the most prosperous regions in the world with GDPs running at $14. investment capital flowed from Europe to the US and the EUR/USD dropped by nearly 2. Trade and Capital Flows: Trade flow refers to how much income a country earns through trade. The Political Theatre in Euro Zone as mentioned above due to worsening of relationships is relatively unstable than US. Debt Concerns.A euro seems to have a dismal future in short term. This could 19 . then the Dollar will appreciate and Euro will depreciate.9% rate. the general rule of thumb in the currency market is that politics almost always trumps economics. it is apparent that the severe slow-down is seen in U. The Interest rates forecasted for US T-bills are expected to fluctuate on higher side a bit but Euro zone for the last sixteen consecutive months had the same interest rates stagnant at 1 % and is expected to maintain the same.7% rate at the end of June while the US expanded at a healthy 2.S. The history of Forex is filled with examples of political trades.62 trillion and $13 trillion respectively. where President Barrack Obama is introducing newer reforms for betterment and saving its party in upcoming elections. the bigger the likelihood that foreign investors will invest in a country's financial markets.

In 1999. dollars. it shows Dollar will continue to appreciate in the near future till Euro zone restores and recovers from sovereign debt crisis. The advantage is that oil and gas price is established in U. This meant that the US had less gold as people starting converting the U. with complex economic effects.S.S. economic growth. but the process proved to be a challenging one which required time. In 1960 USA was confronting with what was called Triffin’s Dilemma. euro is a currency that cannot be ignored on the international financial markets. and can result in very large move against the Dollar in the near-term but at the same time the view that the Euro Zone may face another round of major sovereign debt concerns. nations adopted the U. the cash euro was introduced. dollars in the system the citizens began to speculate. To Sum Up: There are various factors which play a major role in Forex market and determine the exchange rates apart from the import and exports data.S. There are several 20 .S. dollar was overvalued.cause investors to begin questioning the need to hold U. The most traded pair is the U. soon the dollar had become more valuable than gold. dollar had after the World War II. dollars. geo politics and the inter relationships between the states and member countries. This meant that the use of a national currency as global reserve currency leads to a tension between national monetary policy and global monetary policy.S. This means that all the countries in the world that import oil will need dollars for buying it. and all the other currencies were exchanged into USD. In 2002. Because many nations preferred holding reserves of dollars instead of converting them into gold. Even so. the picture may change.S. Due to the supremacy the U. With less gold in the country there was even more speculation that the U. European politicians tried to seek a greater economic integration between European countries. dollar / euro. Consequently. In the same time USA had to run a balance of payments current account surplus to maintain confidence in the U. This in turn allegedly allows the US government to gain revenues through seignorage and by issuing bonds at lower interest rates than they otherwise would be able to. well balanced and stable political and economical status also helps in understanding the movement of exchange rates. CONCLUSIONS After World War II. dollar. dollar exchange rate. Since European nations have alltogether a powerful economy. dollar was overvalued. the importance of interest rates. plans for a single European currency began in 1969. As a result the US government can run higher budget deficits at a more sustainable level than can most other countries. the USA was supposed to run a balance of payments current account deficit to provide liquidity for the conversion of gold into U.S. trade and capital flows.S.S. It is impossible to run a balance of payments current account deficit and surplus at the same time. When applied to Dollar and Euro. But in the long run. a non-physical form of euro was adopted by the states forming the European Economic Community. But with more U. Dollars. thinking that the U. respectively a long-run volatility of the exchange rate. USA will not renounce to having the principal reserve currency in the world just because of this. this pair proving to have a short-. dollars to gold and taking it offshore. This meant that in order to sustain the Bretton Woods system.S. The USD was backed by gold. This higher the demand for oil results in higher demand for dollars.S.

factors which influence the exchange rate between the http://www.S. The relationship the U. The exchange rate U. This would balance the economy and it should also be a solution for Triffin’s we can mention some factors which in turn affect the demand and supply such as: the business OPEC and especially China are rethinking the www. dollar / British sterling pound is greatly influenced by the permanent debate upon UK joining the European Monetary Union. Nowadays.htm 21 .infomondo. all the other economic powers like www. This may be due to the fact that Romania does not have a strong economy to support the effects of all influencing factors.about. political factors and economic data.eu4journalists. stock market. dollar and the euro. If we analyse the relationship between euro and the Romanian www. some countries. it can be seen that with the exception of short periods.fgmr.ziare. China states that the principal reserve currency should be a basket of currencies like Japanese www. As for the www. As for the pair U. Due to its low level of interest rates. the British sterling pound or the Swiss franc is also important to www. the Romanian leu has constanly depreciated against the euro.investopedia. countries in this will have as a specific characteristic the safety the Swiss franc is thought to have. the yen is attractive to investors. euro. dollar / Swiss franc. especially OPEC.mees.html http://useconomy. dollar has with currencies such as the Japanese yen. dollar and possible also Russian rouble. so they do not rush in taking a decision that might bring them But meanwhile USA does not even want to hear about www.html www. The most two important are the level of the interest rates and the dual forces of demand and REFERENCES: www. Chinese trillion dollars reserves.independent.scientificamerican. hold about 2.

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