Financial Markets and Institutions (2-downloads)

The Euro’s Challenge 

to the Dollar

With the creation of the European Monetary System

and the euro in 1999, the U.S. dollar is facing a

challenge to its position as the key reserve currency

in international financial transactions. Adoption of the

euro increases integration of Europe’s financial mar-

kets, which could help them rival those in the United

States. The resulting increase in the use of euros in

financial markets will make it more likely that interna-

tional transactions are carried out in the euro. The

economic clout of the European Union rivals that of

the United States: Both have a similar share of world

GDP (around 20%) and world exports (around 15%).

If the European Central Bank can make sure that

inflation remains low so that the euro becomes a

sound currency, this should bode well for the euro.

However, for the euro to eat into the dollar’s posi-

tion as a reserve currency, the European Union must

function as a cohesive political entity that can exert

its influence on the world stage. There are serious

doubts on this score, however, particularly with the

“no” votes on the European constitution by France

and the Netherlands in 2005 and the recent fiscal

problems in Greece. Most analysts think it will be a

long time before the euro beats out the dollar in inter-

national financial transactions.

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Part 5 Financial Markets

therefore have to sell the anchor currency and buy its own to keep its currency from

depreciating. The result of this foreign exchange intervention will then be a decline

in the smaller country’s international reserves, a contraction of its monetary base,

and thus a decline in its money supply. Sterilization of this foreign exchange inter-

vention is not an option because this would just lead to a continuing loss of interna-

tional reserves until the smaller country was forced to devalue its currency. The smaller

country no longer controls its monetary policy, because movements in its money sup-

ply are completely determined by movements in the larger country’s money supply.

Another way to see that when a country fixes its exchange rate to a larger coun-

try’s currency it loses control of its monetary policy is through the interest parity con-

dition discussed in the previous chapter. There we saw that when there is capital

mobility, the domestic interest rate equals the foreign interest rate minus the

expected appreciation of the domestic currency. With a fixed exchange rate, expected

appreciation of the domestic currency is zero, so that the domestic interest rate

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