Question

Generally speaking, how is the dollar price of euros determined? Cite a factor that might increase the dollar price of euros. Cite a different factor that might decrease the dollar price of euros. Explain: "A rise in the dollar price of euros necessarily means a fall in the euro price of dollars." Illustrate and elaborate: "The dollar-euro exchange rate provides a direct link between the prices of goods and services produced in the eurozone and in the United States."Explain the purchasing-power-parity theory of exchange rates, using the euro-dollar exchange rate as an illustration.

Short answer

The dollar price of the euro is determined by the supply and demand of the euro in the market.

A rise in real interest rates in the eurozone and unchanged rates in the US will increase the dollar price of euros.

A rise in the income of Europeans will decrease the dollar price of euros.

The rise in the dollar price of the Euro means a fall in the euro price of dollars because the appreciation of one currency will depreciate another currency and vice-versa.

The exchange rate gives the price of one currency for another currency so that the value of goods and services can be compared and determined in terms of a single currency.

The purchasing power parity theory determines the exchange rate where average costs of goods and services between countries are compared.

Step-by-step solution

Determining dollar price of euros

The market for foreign currency, like euros, determines the equilibrium dollar price of euros. The intersection of the demand-for-euros curve and the supply-of-euros curve gives the equilibrium point, which sets the exchange rate.

Any increase in demand for euros or a decrease in the supply of euros will increase the dollar price of euros and thus cause the euros to appreciate in the world market.

Factor leading to an increase in the dollar price of the euro

Suppose that real interest rates rise in the eurozone but stay constant in the US. Americans will then find Europe a more attractive place to loan money directly or buy bonds indirectly. To make these loans, they have to supply dollars in the foreign exchange market to obtain euros. The increase in the demand for euros results in the depreciation of the dollar and appreciation of the euros. Thus the dollar price of the euro increases.

Factor leading to a decrease in the dollar price of the euro

The dollar price of the euro is likely to depreciate if Europe's income proliferates than America. As the income rises in Europe, European buying behavior will increase. Their imports of US goods will therefore increase the demands for dollars. The dollar price of the euro will fall, the euro will depreciate.

Duality between the dollar price of euros and euro price of the dollar

The price of one currency for another currency means how much of one currency can be purchased from a unit amount of another currency. The fall in the dollar price of euros means there is a decrease in demand for euros or an increase in the supply of euros. Conversely, the fall in the euro price of dollars means a reduction in demand for dollars and an increase in the supply of dollars.

In the first condition, the euro will depreciate (and the dollar will appreciate), and in the second condition, the dollar will depreciate (and the euro will appreciate).

Exchange rate link between the prices of goods and services produced in eurozone and the US

Suppose the exchange rate is $2= 1 euro. The given exchange rate signifies that Americans require $2 to purchase one unit of the good in the eurozone. In comparison, Europeans will need 0.5 euros to buy one unit of the goods in America.

Thus, imports from the eurozone will be costlier for the US economy than exports, which justifies that the relative prices of goods and services directly link with the euro-dollar exchange rate.

Purchasing power parity

The PPP theory is a theory for determining the exchange rate where average costs of goods and services between countries are compared.

The theory is based on extension and variation of the "law of one price," which states that identical goods should be sold for the same price in two different markets when no transportation costs and no differential taxes are applied in the two markets.

According to purchasing-power-parity theory, exchange rates should adjust themselves to equate the purchasing power of various currencies. If a certain market basket of identical products costs $10,000 in the US and 5,000 euro in the eurozone, the exchange rate should be fixed at $2 = 1 euro. So, a dollar spent in the United States will buy exactly as much output as it would if it were first converted to Euro (at the $2 = 1 euro exchange rate) and then used to buy products in the eurozone.