Apr 25 2007
What’s got the dollar so weak in the knees?
Published by Jason Welker at 10:39 am under AP Economics,Balance of Trade,capital account,Exchange Rates,Interest rates,Macroeconomics,Trade
“THE US dollar has dropped to a 27-month low against the euro… The United States currency also tumbled to its weakest level against the British pound in 26 years”
What’s happening to the US dollar? The article claims that “interest rate differentials” are causing the weakening of the dollar relative to the Euro and the Pound. How can this be explained? First of all, why is the US Fed predicted to cut rates in the near future?
“The dollar’s losses last week accelerated after a US government report showed that consumer prices excluding energy and food moderated last month. That contrasted with reports from the United Kingdom and New Zealand indicating accelerating price pressure.”
What’s the connection between slowing inflation in the US, accelerating inflation in Europe, falling and rising interest rates, and the exchange rate? At this point in the AP course, you should be able to explain all of these connections.
How can we explain how the following economic trends lead to a weakening of the dollar and a strengthening of European currencies?
“The yield advantage of 10-year Treasury notes over similar-maturity German bunds dropped to 0.47 percentage point last week, the lowest since November 2004. A narrowing yield gap dims the allure of dollar-denominated assets.”
“The economy in the euro zone will grow 2.3 percent this year, beating the 2.2 percent estimate for the US…”
“ECB council member Axel Weber told Handelsblatt newspaper that an ‘extremely positive’ economic outlook meant the bank can’t signal it’s finished raising rates.”
If you can read, understand and explain this article right now, they you probably understand most what what you need to understand from Chapter 38. Let’s hear your comments, folks!
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About the author: Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course.
Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this authorRelated posts:
slowing inflation in the US compared to accelerating inflation in the UK causes the purchasing power of the dollar to decrease because now one dollar can buy less British import. the decrease in purchasing power leads to the depreciation of dollar. Thus, the dollar has weakened relative to the Euro.
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Slowing inflation in the US will raise the value of the dollar, but accelerating inflation in Europe will raise the price level in Europe. Thus most US dollars will be required to purchase European goods, depreciating the dollar.
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Let us consider the exchange rate between the U.S. dollar the Euro. One dollar is worth about 0.78 Euros right now. The demand for Euros in the international market is downward sloping, which implies that the quantity of the euro demanded will be greater when the dollar price is lower. This makes sense: More people and firms would want to acquire euros if they could get a lot of them for each dollar. The supply curve for euros is upward sloping, which implies that the quantity of euros supplied will be grater when the dollar price is higher. again, this makes sense: more people would be willing to part with their euros if they could get more cents for each one.
The article claims that differentials in the interest rates of both nations is influencing the exchange rates between the two country's currencies. If interest rates in the US are higher (in efforts to combat inflation) then it will be more rewarding to lend money in the US. However, a european wanting to lend money in the states must first turn her euros into dollars. This increases the demand for euros. The demand curve for euros shifts to the right, resulting in a rise in the dollar value of the euros (appreciation) and an increase in the amount of euros exchanged. Or looked at from the other side, the dollar has "depreciated" vis-a-vis the euro.
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Since the United States has such a large trade deficit, that's a sign that the dollar is overpriced. If currency exchange rates were completely floating, the dollar should have depreciated more, especially with regard to the Chinese rmb. Depreciation of the dollar would make US goods relatively less expensive to China and Chinese goods relatively more expensive to Americans, which would cause imports to decrease and exports to increase.
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