Changes in the exchange rates between two currencies depend on changes in the demand or supply of one or both currencies. Demand for a currency can be determined by inflation, income, government spending, foreign investor interests and future expectations. Supply is regulated using monetary policy (changes in interest rates and money supply) by the Central Bank of a country or monetary union. The changes in the Euro/Dollar exchange rates during the period 2006-2013 were largely caused by the economic factors of domestic inflation and interest rates, the political factor differences in government policy between the US Federal Reserve and the European Central Bank (ECB), and investors’ expectations.
In the first quarter of 2006, the Euro was relatively weak at $1.18/€1. From that point onwards the Euro/Dollar exchange rate started to rise steadily, reaching an all-time high of $1.59/€1 in April 2008. The reason for this was the world financial crisis started in the US and which led to a global recession. Demand for the Dollar fell as investment banks went bankrupt when the US housing sector became worthless. To deal with the credit crisis and to get out of recession, the US Federal Reserve applied expansionary monetary policy by injecting large amounts of money into the economy and by reducing interest rates to almost 0%. The rise in supply and fall in demand for dollars (since saving in the US was now less attractive for foreign investors due to lower interest rates) lowered the value of the Dollar.
On the other hand, the ECB waited several months longer to implement its monetary policy, and it never took its interest rates as low as the US (only to 1% in 2008). The ECB also did not employ the Federal Reserve’s method of quantitative easing (buying up long-term financial assets from commercial banks) which was aimed to further increase money supply and stimulate the economy. With a smaller supply of money in the European economy and a higher interest rate...
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