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On a Par
Subject Tariffs
Topic Exchange Rates, Monetary Policy
Key Words Monetary Policy, International Trade, Interest Rates
News Story

During this past year, the dollar has depreciated about 12 percent relative to the euro. After last week's interest rate cut by the Federal Reserve, it takes $1.01 to buy one euro, a three-year low. Many analysts predict that the dollar will fall further, perhaps to $1.10, by the end of 2003. A lowered dollar means that European vacations will be more costly for American tourists and the price of our exports will decrease. Whether the dollar will fall further depends in large part on how the American economy performs.

The flight from the dollar to the euro is apparently not the result of confidence in the future of the European economy. In fact, the forecast for 2003 for the European Union is slower growth than in the United States. Analysts believe that interest rate cuts, the U.S. current account deficit, which could reach $500 billion this year, and disappointment with the performance of the American economy, are primarily responsible for the fall in the dollar.

Current U.S. economic growth is below potential growth, with many economists forecasting that the economy will grow only 2.5 percent next year. Potential growth, the growth rate that the economy can sustain without inflation, is estimated to be between 3.0 and 3.5 percent. When U.S. economic performance is weak, there is a reduced incentive for foreigners to invest their capital here and fund the current account deficit.

Analysts are expecting an additional 10 percent drop in the dollar. In July of this year, the dollar fell to parity with the euro and as analysts were predicting further drops, the dollar rallied and fell below $1. If economic performance improves, perhaps as a result of the Federal Reserve's recent interest rate cut, the dollar could reverse course and fall below $1.


(Updated January 2, 2003)

Questions
1.

What are some of the important determinants of the exchange rate between the dollar and the euro?

2. How important are exports in terms of U.S. gross domestic product? Imports?
3. How does the slowdown in the U.S. economy affect U.S. exports and imports? European exports and imports?
4. Explain what is meant by a current account deficit. How large is the current deficit?
Source Jonathan Fuerbringer, "Dollars and Euros: A Look Beyond the Parity Line," The New York Times, November 10, 2002.

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