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Why Does the Euro Keep Rising Against the Dollar?

November 4, 2010

The U.S. Federal Reserve Bank (“the Fed”) announced yesterday that it would begin pumping $600 billion into the U.S. economy as part of a program of quantitative easing.  In essence, this means that the Fed will create $600 billion by buying bonds.  As a result, stocks rose, including across Europe, and while the dollar fell against major currencies.  As a result, the dollar finished the day being worth about €0.71.  This may strike Americans as strange that while European leaders meet last week to agree on rules that would hopefully prevent any future bailouts; the U.S. dollar is actually falling against the euro.  As the below graph shows, the euro has more than regained any declines following the Greek Bailout in May, and is now actually at its highest point since January.

There are three reasons (and probably more) to help explain the high euro:

  1. Part of the reason for the cheap dollar is simple supply and demand.  The Fed is expanding the supply of dollars and if the demand stays the same, then the price of the dollar (or its exchange rate) must drop to a new equilibrium.
  2. Secondly, markets fear inflation.  Inflation would erodes the value of the money that people currently hold, since it means you can buy less with the same amount of cash.  The European Central Bank (which controls the monetary policy of the euro) has shown that it is very allergic to inflation.  The ECB actually has a mandate to keep inflation around two percent, and the ECB announced in August that it would keep the Greek Bailout “inflation neutral.”  Part of this fear of inflation stems from Germany, which is both very proud that it has kept inflation low since the Second World War, but also still fears the specter of inflation, as hyperinflation in the early 1920s was one of the causes of Hitler’s rise to power.
  3. Thirdly, the engine of the European economy—Germany—is doing well, growing at two percent in the second quarter of 2010.  This growth has helped other European economies, such as Austria and the Netherlands, and helped cancel out the effects of other weaker Eurozone economies, such as Greece and Ireland.  In fact, the interest rate on Irish government bonds has reached record highs, but this news does not appear to weaken the euro.

The euro and its relationship with the dollar and the U.S. is one of the most important influences the EU has on the U.S., and to better understand this connection, we are sponsoring the “Euro and the Midwest” luncheon.  This event will be on November 18 in Indianapolis, and will feature Dr. Christopher J. Waller, who is the Senior Vice President and Director of Research at the Federal Reserve Bank of St. Louis as well as a professor at the University of Notre Dame.  More information, including how to register, is available at here.

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