South-Western College Publishing - Economics  
Subject Exchange rate, economic growth
Topic International Finance
Key Words Interest Rates, Exchange Rate, Economic Union, Economic Growth
News Story

The euro, the currency of the European Economic Union, was introduced in January 1999 with hopes that it would become a powerful rival to the dollar. On Wednesday, May 3, 2000, the euro sunk to a new low against the dollar - a decline of 24 percent since its introduction. The reasons for the euro's decline are unclear. European leaders now worry that inflation may increase as the price of imported goods rise and, consequently, interest rates may need to be increased.

The causes of the euro decline are puzzling. The economies of the European nations comprising the EEU are improving. Economic growth and consumer confidence is stronger than it has been in years. High unemployment, a problem that has plagued Europe for many years, is declining for the first time. Exports are booming and inflation is lower than in the U.S. and is expected to fall with the decline in oil prices.

Some analysts feel that the euro's problems are in part the result of political factors. Greece, a country that the EEU rejected for membership 2 years ago has now been recommended for admission by the European Commission and the European Central Bank. Many feel that the admission of Greece will weaken the EEU.

Perhaps it is not the fall of the euro, but the rise of the dollar that we should be focusing on. The growth rate for the European nations does not match U.S. growth. Expectations of future interest rate hikes by the Federal Reserve are pushing the dollar up and capital inflows will follow the higher rates. The argument against this hypothesis is that the euro is losing ground to most other major currencies.

(Updated June 1, 2000)

1. What is an economic union? What are the goals of the European Economic Union?
2. What is the exchange rate? What determines the demand for foreign exchange? The supply of foreign exchange?
3. How is the exchange rate determined? Suppose there is an increase in the demand for one currency vis--vis the other, what will happen to the exchange rate? Explain your answer.
Source Edmund L. Andrews, "No Rescue In Sight as Euro Slides To New Low," The International Herald Tribune, May 4, 2000.

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