The basic theories underlying the US dollar to euro exchange rate
Law of One Price: In competitive markets, free of transportation cost barriers to trade, identical products sold in different countries must sell at the same price when the prices are stated in terms of the same currency.
Interest rate effects: If capital is allowed to flow freely, exchange rates become stable at a point where equality of interest is established.
The dual forces of supply and demand
These two reciprocal forces determine euro vs. US dollar exchange rates. Various factors affect these two forces, which in turn affect the exchange rates:
The business environment: Positive indications (in terms of government policy, competitive advantages, market size, etc.) increase the demand for the currency, as more and more enterprises want to invest in its place of origin.
Stock market: The major stock indices also have a correlation with the currency rates, providing a daily read of the mood of the business environment.
Political factors: All exchange rates are susceptible to political instability and anticipation about new governments. For example, political instability in Russia is also a flag for the euro to US dollar exchange, because of the substantial amount of German investment in Russia.
Economic data: Economic data such as labor reports (payrolls, unemployment rate and average hourly earnings), consumer price indices (CPI), producer price indices (PPI), gross domestic product (GDP), international trade, productivity, industrial production, consumer confidence etc., also affect currency exchange rates.
Confidence in a currency is the greatest determinant of the real euro to US dollar exchange rate. Decisions are made based on expected future developments that may affect the currency.
Types of exchange rate systems
An exchange can operate under one of four main types of exchange rate systems:
Fully fixed exchange rates
In a fixed exchange rate system, the government (or the central bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target. It is committed to a single fixed exchange rate and does not allow major fluctuations from this central rate.
Semi-fixed exchange rates
Currency can move within a permitted range, but the exchange rate is the dominant target of economic policy-making. Interest rates are set to meet the target exchange rate.
Free floating
The value of the currency is determined solely by supply and demand in the foreign exchange market. Consequently, trade flows and capital flows are the main factors affecting the exchange rate.
The definition of a floating exchange rate system is a monetary system in which exchange rates are allowed to move due to market forces without intervention by national governments. The Bank of England, for example, does not actively intervene in the currency markets to achieve a desired exchange rate level.
With floating exchange rates, changes in market supply and demand cause a currency to change in value. Pure free floating exchange rates are rare - most
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