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The dollar and euro exchange rates break even

The euro hit “parity” with the U.S. dollar for the first time in nearly 20 years on Wednesday, July 13, 2022. That is, the exchange rate dropped to $1.00 per euro. It quickly rebounded and has been hovering around $1.02 at of the time of this writing. What are the forces behind these changes, and how might we use data to illustrate them?

Interest rate parity theory suggests that the interest rate in the U.S. should equal the interest rate in the eurozone, plus the expected depreciation of U.S. currency. The basic assumption underlying this theory is that there is no arbitrage between deposits in different currencies. Thus, if interest rates are higher in the U.S. than in the eurozone, then it has to be the case that the dollar will eventually depreciate (i.e., lose value) vis-à-vis the euro. If markets are expecting the U.S. dollar to depreciate tomorrow, today’s value tends to be high. Thus, exchange rates tend to broadly follow movements in the difference between interest rates.

We see in the FRED graph above that, especially in the more recent period, the dollar-to-euro spot exchange rate tends to fall when the difference between the federal funds rate and the ECB deposit rate is positive. When this exchange rate is lower, the dollar is more valuable relative to the euro.

What does the lower exchange rate mean for U.S. consumers? The lower exchange rate, or the stronger dollar, will allow holders of U.S. currency to get more euros, and thus products in Europe are cheaper than usual. Typically, a strong domestic currency is good for consumers because importing products is cheaper; but it’s bad for domestic producers because international customers have to pay more for domestic exports.

How this graph was created: We take the first line as the federal funds rate (FEDFUNDS), click on “Edit Graph,” add the series for the European central bank rate for the euro area (ECBDFR), and apply the formula a-b. Then add a second line in the “Add Line” tab and put in the dollar-euro spot exchange rate (DEXUSEU) and change this line to the right axis in the “Format” tab.

Suggested by Miguel Faria-e-Castro and Samuel Jordan-Wood.

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