Factors Influencing Exchange Rate Between the US Dollar and Euro - Essay Example

Factors Influencing Exchange Rate between the U.S. Dollar and Euro Factors Influencing Exchange Rate between the U.S. Dollar and Euro A look into the performance of dollar shows that it fell by 30% against euro in the year 2010. As Rahn (2003) points out, in the place of the 80 cents one had to pay for each euro in 2009, presently, one has to pay 1.24 dollars per euro. While some scholars argue that a further fall is in the pipeline, a rational assumption is that as dollar already reached its minimum, its value is likely to improve in the coming years.

The various factors that are considered as influencing factors on dollar-euro exchange rate are the international real interest rate differential, relative prices in the traded and non-traded goods sectors, the real oil price, and the relative fiscal position (Dollar-euro currency exchange). A look into the various analytical works prove that the main reason behind the present fall in dollar value is the large trade deficit, which, in turn, was created by the flow of foreign investment dollars into the US economy.

One can say undoubtedly that the world countries will not let the dollar go down as such a fall will adversely affect their own national interests. To illustrate, the US economy offers more return on capital than its European counterparts. As a result, foreign governments, especially the Asian giants like China, Japan and India, have purchased considerable amounts of US dollars as reserve backing for their own currencies. So, a significant fall in the dollar will have an adverse impact on these investor economies.

Admittedly, the present day fall in dollar value is primarily as a result of the decline in private foreign investment and is in no way connected with foreign governments. Before its fall, dollar witnessed a sharp rise against the euro, and because of this growth, there arose a belief among private investors that dollar has become too expensive to afford. So, there was a natural shift towards euro as the only other option. As a result, dollar came down the way it went up. Now, experts point out that as far as America manages to offer a higher return on investment, it will remain as the primary destination of investment for foreign banks and private investors.

As the demand for dollar will grow again, the current deficit will be overcome. However, there are certain governmental initiatives that have already tarnished the image of America as an investor-friendly nation. Some examples are the Patriot Act and the Sarbanes-Oxley Act. As a result of such provisions (as reported by The Economist ) that require extensive paperwork and offer the threat of privacy intrusion, foreign investors have lost interest in the America economy. In the opinion of Gene Epstein, in order for dollar to further collapse, there conditions should exist at the same time.

First of all, there should be an existing weakness for dollar that makes investors look for other options. Secondly, there should be another more beneficial option, and thirdly, there is the need for a triggering event. It is pointed out by the scholar that the first option is already in place. This is so because dollar has already fallen by more than 30% in a period of one year. However, the problem is that there is no viable alternative at present for dollar. According to Epstein (2011), this is so because while 61% of the foreign currency reserves are in dollars, the nearest rival euro only has 30% of the reserves.

In addition, there is the debt crisis faced by the euro-zone. As a result of all these, one cannot consider euro as a viable alternative to dollar. The third point is the occurrence of a triggering event. In the case of dollar, a possible triggering event is the dumping of treasury notes on the secondary market by foreign governments. If such a measure is taken by countries like China or Japan, there will be panic in the market leading to dollar collapse. However, a look into the business tactics of these nations proves that such a step is unlikely from either of them.

To illustrate, it is a known fact that China has nailed its Yuan to dollar in an effort to keep its exports to the US cheaper. Thus, if it resorts to such measures that will cause a fall in dollar, China will lose its position as the cheapest exporter. Very similar is the case of Japan too. The nation wants to promote exports to the US, and the only way in front of them is to keep dollar high. So, despite its 800 billion dollars of treasury notes, Japan will not try to dumb the dollars as far as the nation wants to depend on exports.

However, one cannot turn a blind eye towards the distant possibility of other nations becoming better markets than the US. Still, as far as US is the best market in the world, the investors will not let dollar go uncontrollably down. References Dollar-euro currency exchange. Easy Forex. Retrieved from http://classic.easy-forex.com/en/Forex.dollareuro.aspx Epstein, G. (2011). Milton Friedman’s Euro Smack down. Barron’s. retrieved from http://online.barrons.com/article/SB50001424052702303544204576542853219931480.

html Rahn, R. W. (2003). How far will the dollar fall? Washington Times, 30 December. The rise and fall of the dollar: Go with the flows. The Economist. Retrieved from http://www.economist.com/node/17956749