Exchange Rates: Why a Strong Euro Isn't Always Good

An exchange rate is the price at which one currency trades for another. When you see EUR/USD = 1.08, it means one euro buys 1.08 U.S. dollars. Exchange rates are quoted for virtually every pair of currencies, though most global trade and finance is settled in a small number of dominant currencies — primarily the U.S. dollar, the euro, the Japanese yen, and the British pound.

How the EUR/USD rate works in practice. If EUR/USD moves from 1.08 to 1.15, the euro has appreciated — it now buys more dollars. If it falls from 1.08 to 0.98, the euro has depreciated. For a European traveler going to the United States, a stronger euro means cheaper American hotels, meals, and goods. For an American company buying European machinery, a stronger euro means higher costs.

What causes exchange rates to move? Exchange rates in floating systems (like the euro, dollar, and most major currencies) are determined by supply and demand in global currency markets — the largest financial market in the world, with roughly $7.5 trillion in daily trading volume (BIS Triennial Survey, 2022). The main drivers:

1. Interest rate differentials. When a country's central bank raises interest rates, foreign investors earn higher returns on that country's bonds and deposits, increasing demand for the currency and pushing it up. This is the most powerful short-to-medium-term driver of exchange rates. The U.S. Federal Reserve's aggressive rate hikes in 2022 (from near zero to over 4.5%) drove a major USD appreciation as global capital flowed toward higher-yielding dollar assets.

2. Inflation differentials. A country with higher inflation sees its purchasing power erode; over the long run, currencies of high-inflation countries tend to depreciate relative to low-inflation ones. This is the insight behind Purchasing Power Parity (PPP) theory.

3. Trade balances. A country that exports more than it imports generates net demand for its currency (foreign buyers must purchase the currency to pay for goods). Germany's persistent trade surplus has historically supported euro demand.

4. Market expectations and speculation. Currency markets are forward-looking. Expectations about future interest rates, growth, political stability, or geopolitical risk can move exchange rates significantly and rapidly — sometimes far beyond what fundamentals would suggest.

Sources: BIS, Triennial Central Bank Survey (2022); ECB, Exchange Rate Statistics; Krugman, Obstfeld & Melitz, International Economics: Theory and Policy (11th ed.).