Euro vs. Dollar: Exchange Rate Fluctuations Explained

Introduction: The Euro's Decline in 2005

Floating exchange rates reflect current events and future expectations, and there are many reasons for their continual fluctuations. A brief examination of events in Europe and the United States illustrates how quickly exchange rates can change and what propels them to do so. The article "Euro Falls to 2-Year Low Against Dollar" (Waki, 2005), which appeared in The Moscow Times, succinctly describes the exchange rate situation between the euro and the dollar and the main reasons for these developments.

As of the early hours of November 10, 2005, the euro fell a quarter percent, holding at $1.1750 (Waki, 2005). This was another drop in a series of recent falls; for example, it traded at $1.793 on November 7, 2005, and at $1.787 on November 8, 2005 (Read, 2005). This is a notable development given that the euro had previously been appreciating steadily. A falling euro naturally signals a stronger U.S. dollar. In fact, on November 8, 2005, "the dollar rose to its highest level against the euro in nearly two years" (Read, 2005, p. 1). Some analysts speculated that the dollar might continue to rise depending on political, social, and monetary developments in euro-zone countries.

Political Instability and Currency Depreciation

The value of a nation's currency is greatly determined by its political stability and policies. In the presence of political uncertainty, a country's currency is likely to depreciate. This phenomenon reflects a common-sense principle: investors and businesses are naturally hesitant to commit to a nation whose political future is unknown. The risks are too great and the vulnerabilities too numerous for any prudent investor or businessperson.

A clear contemporary illustration of this principle can be found in Germany. Germany's political uncertainty was one contributing reason for the recent depreciation of the euro. The German elections sparked controversy and upheaval when then-Chancellor Schröder "refused defeat" (The Economist, 2005, p. 53). Angela Merkel, who promised to form a "grand coalition," found the task increasingly difficult as some of her colleagues resigned and several leaks provoked further controversy. With setbacks occurring frequently and stalling the nation's political machinery, it is unsurprising that the euro was falling.

Social Unrest and Its Effect on the Euro

In addition to political insecurity, social unrest greatly influences the value of a nation's currency. Common sense again dictates that a country in the midst of social turmoil is not a prudent choice for investment or business. France was experiencing a protracted series of riots throughout the nation, driven by the perceived and real marginalization of minorities — particularly Arab communities. The state's inability to effectively and efficiently quell the riots only worsened the situation.

Furthermore, there were fears that the riots might spread to neighboring countries, many of which also have significant minority populations. There was evidence to suggest this was already beginning to occur, with cars set on fire in Germany and Brussels in acts of violence and vandalism mirroring those taking place in France. The real social disturbance, coupled with the apparent threat of additional upheaval, adversely affected the value of the euro. In other words, unsafe social conditions and the expectation of further unrest resulted in a depreciating euro.

Conclusion: Key Drivers of Currency Valuation

There are several factors that contribute to the appreciation or depreciation of a nation's currency. Political, social, and economic conditions hold great sway over which direction a currency moves — whether it appreciates, depreciates, or remains stable. Equally important are the expectations — either positive or negative — that investors and markets hold about a country's future conditions. Current events in Europe and the United States in 2005 neatly illustrate these foundational economic principles.