The euro has depreciated more than 20% against the US dollar over the past year and sank to $1.0842 on March 6, hitting an 11-year low against the dollar for two main reasons: the bond-buying program of the European Central Bank (ECB) and the US jobs report.
First and foremost, the ECB embarked on an aggressive bond-buying program, known as quantitative easing, on March 9. It wants to purchase sovereign bonds and private sector assets for a combined monthly amount of €60 billion until at least September 2016 in order to speed up the dangerously tumbling inflation rate and to stimulate the economic growth.
The key question is “what are the effects of this decision on the exchange rate?” Through this monetary policy, the ECB increases the monetary base and the money supply and drenches financial institutions with capital which strengthens investing, lending and liquidity. These increases affect the euro currency in two ways. Firstly, increasing monetary base spurs consumption and leads to inflation which, based on the theory of Purchasing Power Parity (PPP), causes the euro to depreciate. Secondly, since there is more money available for borrowers, this policy decreases the interest rate in the euro zone, causing the euro to depreciate. Why?
Suppose you are an investor who is considering depositing the euro in your account. When the interest rate is low on the euro-denominated bank accounts compared to, say, the dollar-denominated accounts in the US, you prefer to exchange your euro for dollars and deposit your money in the US.
That means the supply of the euro in the market goes up while the demand for it is shrinking. As a consequence, the euro is depreciating especially against the currencies of countries where the comparable interest rate is higher.
The second key question is, “Is a weaker euro bad for the currency bloc’s economy?” As the euro falls against foreign currencies, the price of foreign goods will jump in the euro zone, leading to dwindling demand for foreign goods and higher attractiveness of domestic products. Conversely, the price of euro-zone products will be cheaper for foreigners, so the exports in the euro zone will be boosted, creating more jobs and lowering the unemployment rate.
Second, the newly released US unemployment rate of 5.5%, the lowest since 2008, smashed the Wall Street expectation and entered into the Federal Reserve’s target zone, which keeps the Fed on track to raise the interest rates in the US for the first time in nearly a decade.
Increase in the US interest rate reinforces the demand for US assets as well as securities and causes the dollar to appreciate, especially against the euro which holds a very low interest rate.
Amir Moradi is a PhD candidate in finance.
