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Chapter 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach Euro Strengthens With European Economy By CARTER DOUGHERTY – May 09, 2006 FRANKFURT, May 8 - After a roller-coaster year, the euro appears to be headed firmly on an upward track as Europe’s once-sputtering economy starts firing on all cylinders and the United States dollar weakens against major currencies. A mixture of brisk exports and accelerating economic growth is persuading investors to take shelter in the euro as the dollar continues a relentless downward trajectory. The dollar’s decline - which affects Asian currencies as well - has gained speed since the end of March as the huge United States current-account deficit widens further, and the Federal Reserve signals that it may take a breather in its two-year cycle of raising interest rates. But while the euro has seen its rising fortunes fade in the past, things look different this time, since its fate is not tied solely to the dollar’s whims. Now, a generally upbeat mood in Europe is contributing to its strength -in stark contrast to even a year ago, when the collapse of the European constitution underscored deep uncertainty about the future of the Continent. "Now, things are really happening in the European economy," said Erik F. Nielsen, chief Europe economist for Goldman Sachs. On Monday, the euro hit $1.2787 before slipping to $1.2704, still up sharply from $1.22 in early April. The dollar also eased to 111.69 yen from 112.43 yen on Friday, and continued a decline against the British pound. Jean-Claude Trichet, president of the European Central Bank, cautioned Monday that Europe’s renewed growth could still fuel concerns about inflation at a time when commodity and energy prices were also surging. "It is not the time for complacency if we want this global growth to be sustainable," Mr. Trichet said at a gathering of central bankers in Basel, Switzerland, according to Reuters. "We have to be careful to see that this period of global growth does not end up in inflation." A year ago, the euro’s rise was cause for concern among European businesses and the European Central Bank for a different reason. They worried that a rising currency would make Europe’s exports - then, as now, the backbone of the European recovery more expensive, choking growth. But further evidence of broad economic gains means European officials now view the euro’s strength with interest, and possibly concern, but not alarm. "Life is pretty decent right now in Europe, and European officials feel pretty positive about the economy despite the rising euro," said Simon Derrick at the Bank of New York in London. "There has been a considerable shift in viewpoints." On Monday the European Commission raised its growth forecast for countries using the euro currency to 2.1 percent for this year, up from a prognosis of 1.9 percent in February. Most encouragingly, the commission lifted its outlook for Germany, Europe’s largest economy, to 1.7 percent, slightly higher than its previous estimate of 1.5 percent. Evidence is mounting that consumer spending, an engine of growth that has not fully kicked in, is starting to pick up after a long lull. On Monday, an index of the 12-nation euro zone’s retailing industry by NTC Economics reached its highest level since January 2004, when the poll began. For much of 2004, the dollar was buoyant as the Federal Reserve lifted interest rates far above European borrowing costs, drawing money from around the world into dollar-denominated assets. A speedy American economic expansion also cast a favorable light on the world’s largest economy. Analysts expect the Fed to raise its benchmark rate a quarter-percentage point, to 5 percent, on Wednesday and to signal that future increases will come much more slowly, if at all. In Europe, by contrast, the central bank has made clear that it is determined to lift rates from their present level of 2.5 percent, which is still near historic lows. As the year wears on, growth in the American economy also is likely to slow thanks to higher borrowing costs and ebbing consumer spending. That helped persuade currency traders to begin dumping the dollar now. "This is the beginning of the dollar downtrend that we’ve all been waiting for," said Tony Norfield at ABN Amro in London. "It has arrived." The U.S. current-account deficit, which rose to $804.9 billion last year and is set to go higher in 2006, also haunts the dollar, economists said. The dollar would fall sharply if the rest of the world lost the appetite that is financing this deficit, a potentially nightmarish situation. One reason the rise of the euro has failed so far to ignite much controversy in Europe is that the dollar is falling against a broad range of currencies, economists said. "The euro is playing its part, but not the only part in bearing the brunt of the dollar’s weakness," said David T. Bloom, a currency strategist with HSBC Holdings in London. "That helps mute the political reaction." In late 2004, the euro zoomed upward against the dollar even as other currencies, notably the yen, remained relatively stable, ensuring that European exporters would pay the price for the dollar’s weakness. The development prompted Mr. Trichet to call the fluctuations "brutal and unwelcome," and generated considerable friction with the United States, which at times explicitly encouraged the dollar’s fall. This time around, the dollar has declined against several currencies in Europe and Asia. One result, Mr. Bloom noted, is that the euro’s rise on a trade-weighted average - an important measurement that reflects the impact on exports - has been much more modest, and at the European Central Bank’s monthly meeting last week, Mr. Trichet avoided expressing any worries about the rise of the euro. The central bank’s own trade-weighted index of the euro is still below 104, well under the range of 106 to 109 that inspired Mr. Trichet’s remarks in 2004. Unless the euro rises to about $1.30, or begins swinging wildly, the bank is likely to see little reason for worry, economists said. "As long as the exchange rates do not get erratic, there is not going to be much cause for concern," said Audrey Childe-Freeman with CIBC World Markets in London. 1. The article states "brisk exports" are causing investors "to take shelter in the euro" versus the dollar. What is wrong with this claim? Hint: the author of the article later states "A year ago, the euro's rise was cause for concern among European businesses…" According to the model in chapter 13, what is the real reason why investors want to invest in euro-denominated assets versus dollar-denominated assets? Answer: The statement is unclear. By itself, a rise in exports should not cause a currency to appreciate. A depreciated currency causes exports to become less expensive over time, so that brisk exports should be caused by a depreciated currency. (The effect of economic growth on the exchange rate is ambiguous. As chapter 15 discusses, economic growth in the long run is predicted to cause the real value and cost of a country's goods to fall, but chapter 16 predicts that increased demand of a country's goods—either within a country or in world markets—that can cause accelerating growth in the short run is predicted to cause the value of a country's currency to rise.) What the author of the article probably means is that increased demand of European goods in world markets (which is caused by some unstated factor) is causing European exports to rise and is causing the demand of euros in foreign exchange markets to rise, which causes the value of the euro to rise. Given this trend, investors should expect the value of the euro to rise, which makes assets that will pay in euros seem more attractive. The model in chapter 13 predicts that when the expected rate of return on euro-denominated assets rises, investors increase the demand of euro-denominated assets and euros, causing the value of the euro to rise and the value of the dollar to fall (and the exchange rate to rise). 2. The article states, "an upbeat mood in Europe is contributing to the [euro's] strength." Please explain this scenario using the terms of the model of the foreign exchange market in chapter 13. Answer: Answers may vary. Here is one: An upbeat mood can make European and foreign firms want to invest and produce in Europe instead of elsewhere, which would increase the demand of euro-denominated goods and of assets relative to the demand of dollar-denominated goods and of assets, so that the value of the euro would rise relative to the dollar. Also, an upbeat mood can lead to increased demand of euro-denominated goods which can lead to increased economic production and profits at European firms, thereby increasing rates of return on their stock and yields on their bonds. If individuals and institutions are expected to want to buy more euro-denominated goods and assets, then the value of the euro is expected to rise and we would represent this by increasing the expected exchange rate in the model. As the model adjusts towards equilibrium, the current value of the euro would rise and the current exchange rate would rise. 3. The article states in 2004 "the dollar was buoyant as the Federal Reserve lifted interest rates far above European borrowing costs, drawing money from around the world into dollar-denominated assets" and that "future increases [of U.S. interest rates] will come much more slowly, if at all. In Europe, by contrast, the central bank has made clear that it is determined to lift rates…." Please explain this scenario using the terms of the model of the foreign exchange market in chapter 13. Hint: see figures 13-5 and 13-6. Answer: When the Federal Reserve System was raising interest rates, rates of return on dollar-denominated assets were increasing so that the value of the dollar was increasing and the dollar/euro exchange rate was decreasing. This scenario is shown in figure 13-5. When the Federal Reserve System appeared finished with increasing interest rates and the European Central Bank was expected to raise its rates, then the expected rates of return on euro-denominated assets increased, so that the value of the euro increased and the dollar/euro exchange rate increased. Figure 13-6 shows the case where European interest rates increase. The model makes a similar prediction when European interest rates are expected to increase because expected increases in European interest rates would cause the expected value of the euro and the expected exchange rate to increase, thereby causing the current value of the euro and the current exchange rate to increase.