Euro Dollar Exchange Rate
I. ASPECTS OF THE EURO DOLLAR EXCHANGE RATE :
Since Organization of Economic Cooperation and Development (OECD) countries have learned to live with rather volatile dollar exchange rates, even high Euro dollar volatility should not pose major problems in principle. However, exchange rate volatility negatively affects investment, so that a rational exchange rate policy will try to dampen excessive volatility. An important question is whether switching from Enterprise Risk Management (ERM) to European Monetary Union (EMU) will increase the variability of the dollar exchange rate.
II. MAJOR IMPULSES FOR EXCHANGE RATES
Major impulses for exchange rates movements should be the following :
Differences in monetary growth rates or changes in the ratio
Differences in output growth in Euro land and US.
The trans-Atlantic interest rate differential
Other impacts
Both the monetarist (M) model of the exchange rate and the Dornbusch (D) model suggest this, although the reaction of the exchange rate to changing trans-Atlantic interest rate differentials has different signs in these two models. A relative increase of the Euro interest rate will cause an appreciation of the Euro, while the monetarist model suggests depreciation. The main reason for these different reactions is that with sticky prices, the liquidity effect will dominate in the short run and rise of the interest rates indicate an expansionary, inflationary monetary policy, so that the fisher effect becomes crucial. Some what different exchange rate behavior is suggested by models with currency substitution. If one assumes that the nominal interest rate reflects expectations of the growth rate of the nominal money supply, we have an additional term compared to the monetarist model which suggests that the domestic currency will depreciate in case of the variance of nominal interest rates. A strong impact of this term can only be assumed with relatively strong risk aversion.
III. EURO DOLLAR EXCHANGE RATE IS IT FUNDAMENTAL
The evolution of the euro exchange rate, the main international currencies and particularly, the US dollar, has given rise to a growing literature. Contrary to the more or less general expectations of appreciation the euro has been in its first three years of existence, depreciating against the dollar. Many arguments have been given in search of fundamentals, but the results are up to now puzzling. Two arguments can be put forth to support this fact. First, an analysis based on fundamental cannot be performed on a short term basis. Although the operators in the money markets seem to be working in a chartist world, from a policy oriented view, the data span has to be long enough to capture the long run equilibrium relationships, and the econometric framework based on co-integration is the most appropriate methodology for this purpose. Second and related to the preceding argument, the absence of historical data for the euro makes it necessary to use aggregate variables to expand the series backward. This synthetic euro area variable has an important qualification they summarize the evolution of the legacy currencies that developed in the framework of rather heterogeneous economic environments. This heterogeneous character and its contribution to the strength of the euro were pointed out.
IV. IMPACT OF NEWS ON THE EURO-DOLLAR EXCHANGE RATES
A number of recent papers have examined the impact of so called news on the euro-dollar exchange rates. These studies have the assumption that foreign exchange markets are efficient in common, meaning that all information relevant for the pricing is instantaneously reflected in the exchange rate. The exchange rate reacts to new information that may be relevant for exchange rate pricing, just as news on economic developments or on monetary policy.
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