The Euro-Dollar exchange rate

Abstract

Foreign exchange is the largest market and is affected by the amount of trade undertaken by a country, investment in securities and central bank intervention. This research seeks to analyse the determinants of the Euro-Dollar exchange rate through a regression analysis based on a long run error correction model. Theory seems to hold best from 2005 onwards, that is, when the Euro-Dollar exchange rate started gaining foothold and became more widely accepted. The short run variables which have a significant impact on the Euro-Dollar exchange are: the interest rate; foreign exchange reserves; monetary growth and the fuel index. The interest rate and the foreign exchange reserves have the largest impact on the exchange rate and hence decision makers should primarily pay close attention to these variables. Monetary growth and the fuel index variables have a negative impact which is much lower than the other two variables. The fact that the fuel index has a negative relationship with the exchange rate indicates that as the USD loses value, energy prices tend to rise so as to maintain suppliers' purchasing power. In terms of the long run error correction model, the ratio of HICP to the Euro-Dollar Level is around 0.75 which is very close to 1, indicating that the exchange rate does internalise price level movements in the long run. Market agents value interest rate stability which in turn provides market confidence and encourages investors and governments to hold the single currency as a reserve leading to an appreciation of the value of the Euro against the Dollar. Structural reforms and austerity measures are necessary for those countries which have found themselves in turmoil so to avoid negative impacts on the Euro.