What drives the Euro/Dollar Exchange rate?
Département analyse et prévision
The euro/dollar exchange rate has undergone large changes in the
last five years. Foreign exchange (FX) markets were volatile and oftentimes
disconnected from economic fundamentals, giving way to
speculative movements towards which Asian Central Banks also contributed.
The dollar's weakness since 2002 is closely related to whether
the twin deficits are deemed sustainable. Uncertainties on the FX markets
led some actors to disregarding economic fundamentals for some
mimicking behavior which, in turn, amplified this disconnection. We stress
this speculative drift via an econometric analysis where a cointegrating
relationship links the euro/dollar exchange rate to its theoretical determinants:
these have fortunately fallen back into favor since early 2003
and the renewed attractiveness of the US (reduction of current deficit
and growth dynamism), together with a potential tightening of the US
monetary policy, incline towards a re-appreciation of the dollar's
JEL Codes: F01, F31, F37.