Determinants of an exchange rate

Seminar paper from the year 2005 in the subject Business economics - Banking, Stock Exchanges, Insurance, Accounting, grade: 1,3, California State University, Fullerton, course: International Economics, 8 entries in the bibliography, language: English, abstract: This paper will discuss the general relationship between the two major currencies of the world: the US-Dollar and the Euro and the determinants for the exchange rate fluctuations
since the introduction of the Euro as the common currency of Europe during the period
between January 1999 and November 2005. Since the introduction of the Euro as the common
currency of the European Monetary Union (EMU) in 1999 this relationship was first
characterized by a sharp depreciation of the Euro followed by a three year lasting appreciation
of the same that passed over in a slight depreciation again from the beginning of 2005 in the
long run.1 This paper will first focus on the History of the international currency exchange
system from the 19th century until the end of the Bretton Woods System in 1973 and on the
history of the currency system in the European community. It will then discuss the general
determinants of exchange rates in the short and long run. It will be pointed out that in the
short run interest rate differentials and expectations of international portfolio investors matter
and in the long run the economic fundamentals such as inflation rates and GDP growth rates
of either economic region are the main factors for the behaviour of the exchange rate. In this
context the theories of the Law of one price and the purchasing power parity are introduced.
In the third part of the paper the exchange rate theories introduced in the previous part are
applied to the -$ exchange rate in the time period between 1999 and 2005. Thus, the short
term and long term factors are used to explain the relationship between the two currencies in
this period. Finally, the last part serves as a conclusion.