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Shoring Up Hope for the Euro
Subject The euro
Topic International Finance
Key Words Exchange Rates, Inflation, Economic Growth
News Story

Europe's hopes for the euro to become a premier international currency have been beset with problems. The euro, which was first introduced on January 1, 1999 at $1.17, continues to fall to record lows. Europe's euro problem has become a U.S. problem that led to the Federal Reserve's recent intervention in the foreign currency to prop up the euro.

The U.S., European banks and the other G7 countries entered the foreign currency market last week to purchase $3 billion worth of euros. The action by these countries was in response to a euro that traded below 85 cents, a 27 percent decline since the euro's introduction, and the fear that speculators were now eyeing the euro and could cause the euro to fall below 80 cents. A falling euro increases U.S. prices to firms in the 11 European countries that have adopted the euro. Rising prices discourage exports and U.S. firms lose sales both in Europe and in other places where U.S. firms compete against European firms. A euro that continued to fall would threaten world economic growth.

Although the economies of the countries of Europe are doing very well, experiencing growth rates of 3.5 percent, increases in worker productivity, and reductions in unemployment rates, Europe suffers by comparison to the U.S. where growth is measured at 5.3 percent. Many feel that European growth has peaked because of the regulations and constraints on commerce. As a consequence, European dollars are flowing to the U.S. stocks and bonds. This props up the value of the dollar and lowers the value of the euro. While the short-run solution may be intervention on the currency market, long-term solutions must be based on economic reforms. There should be greater flexibility in handling workers and greater incentives for firms to engage in efficiency improvements.

Rising oil prices are another reason for the euro's weakness. Higher oil prices have resulted in inflationary pressure in Europe. Because oil is priced in and paid for in dollars, oil prices have risen 47 percent in Europe, compared with a 28 percent rise in the U.S. The European Central Bank has raised interest rates five times this year to dampen inflationary pressures.

(Updated November 1, 2000)

Questions
1.

When the euro was introduced, one euro could be bought for $1.17. Since January 1999, the euro has lost 28 percent of its value. What are some of the factors cited in the article to explain the change?

2. What affect has a decline in the value of the euro vis--vis the dollar had on U.S. firms? On European firms?
3. Why did the Federal Reserve intervene to shore up the value of the euro?
4. The article relates that the European Central Bank has raised interest rates five times this year to dampen inflationary pressures. How does an increase in interest rates dampen inflationary pressures?
Source James Cox, "Is currency intervention enough to hold up euro?" USA Today, September 25, 2000.

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