Jul 20, 2022
Economics

EconExtra: Euro/Dollar Parity-What Does this Mean?

The value of the Euro dropped from $1.20 a year ago to $1.00 on July 13, and even dipped below $1 briefly that week. The last time this happened was July 15, 2002, almost exactly 20 years earlier. Why is this happening, and what is the significance beyond the fact that a psychological barrier was broken?

 

The Headlines 

There are two key reasons given for the dollar's increased strength, particularly relative to the Euro.  In the United States, we have been experiencing inflation at levels not seen in forty years, but the European Union has been experiencing inflation as well. One factor impacting the EU more than the US is the energy crisis they are facing as a result of Russia’s war on the Ukraine, and their energy dependence on Russia, particularly for natural gas.  This raises fears of recession in the Euro Zone.  

 

Exchange rates are all about what is going on in one country relative to what is happening in another in terms of both inflation and interest rates. In this most recent bout of inflation here and in Europe, the Fed is expected to increase interest rates faster than the European Central Bank (both are meeting in coming days to set the next rate increase.) This makes the US dollar a more attractive currency to hold, and the US dollar is still a dominant currency for international trade and central bank reserves. In fact, the US dollar is strong against all currencies at this moment. To the extent Europe heads into a recession sooner or more severe than the US, the ECB will likely halt its interest rate increases, and the Euro will likely dip further. Unlike the US Economy, which is running hot, consumer spending in Eurozone has not yet returned to pre-pandemic levels.

 

Winners and Losers

The obvious example of winners when the dollar is strong would be Americans traveling to Europe this summer (except for that heat wave!). The generally stronger dollar also means that foreign goods imported to the US should be cheaper, and this might help dampen inflationary pressures. On the flip side, industries that sell overseas might see lower demand for their products, which would be more expensive now. And companies that do a lot of business overseas may see lower profits if they repatriate their earnings at this lower exchange rate.

 

From the European perspective, the opposite impact will be felt. Demand for their goods and services from abroad may increase as the relative prices fall with the falling Euro, but goods imported to Europe will be more expensive, driving up inflation further. This all makes the job of the ECB in setting interest rates even more difficult than the for Fed.

 

 

Resources

AP provides good general information on the significance of Euro/Dollar parity. And this WSJ podcast is also a good starting point. These are shorter if time is an issue.

 

This NYT article is the most comprehensive on the subject of parity. It gives the history of the Euro and clearly explains the different economic conditions facing Europe and the US, and the resultant challenges faced by the respective central banks. Other good options include this WAPO article and this one from Al Jazeera.

 

Reuters describes the situation in Europe and the ECB’s anticipated interest rate increase this week.


For more on the strength of the dollar worldwide, this NYT article does a good job of explaining how that is measured and what the ramifications of a strong dollar are.

 

(The NYT article links provided should not require a subscription)

 

Lesson Ideas

 

1) Have students review the resources (all if time permits, one of the three more comprehensive articles if time is limited) and answer the following questions.

  1. When was the last time the US dollar and Euro were at parity?
  2. What are the two main reasons given for the recent/rapid decline in the value of the Euro compared to the Dollar? 
  3. What role are the central banks playing in this?
  4. Who are the winners and losers?

 

2) Lesson Extension: Introduce the concept of purchasing-power parity (PPP) with the “Big-Mac Index.” Have students open this interactive article from The Economist on the Big Mac Index. After reading the article, have them play around by changing the base currency and switching from the Raw Index to the GDP-adjusted index for December 2021. Make sure they look specifically at the Euro/US Dollar comparisons.

  1. Explain in your own words what the Big Mac Index is measuring? What economic concept is the Index supposed to be representing?
  2. How much was the dollar overvalued (raw index/Euro as base currency) compared to the Euro in December 2021? Is the dollar more or less overvalued when you switch to the GDP-adjusted figures? Once this index is recalculated for June 2022, how do you think this number will change?
  3. Using the raw index, which countries are the most undervalued compared to the US dollar? How would you explain why they are undervalued? Does this change much for any of them if you use the GDP-adjusted index? (Vietnam and India are good examples.) How would you explain why some of these change a great deal (and some don’t)?

About the Author

Beth Tallman

Beth Tallman entered the working world armed with an MBA in finance and thoroughly enjoyed her first career working in manufacturing and telecommunications, including a stint overseas. She took advantage of an involuntary separation to try teaching high school math, something she had always dreamed of doing. When fate stepped in once again, Beth jumped on the opportunity to combine her passion for numbers, money, and education to develop curriculum and teach personal finance at Oberlin College. Beth now spends her time writing on personal finance and financial education, conducts student workshops, and develops finance curricula and educational content. She is also the Treasurer of Ohio Jump$tart Coalition for Personal Financial Literacy.

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