Fundamental and Nonfundamental Factors in the Euro/U.S. Dollar Market in 2002 and 2003

The goal of this study is to identify factors which can explain the substantial appreciation of the EUR/USD exchange rate in the period from 2002 to 2003. Our analysis has shown that both fundamental and nonfundamental factors seem to have played a role. Regarding fundamental factors, an accommodating U.S. monetary policy in light of a weak labor market as well as the rising U.S. current account deficit contributed to weakening the U.S. dollar and thus strengthening the euro. The Bank of Japan's large intervention purchases of U.S. dollars, which have been widely considered important in the economic policy debate, do not appear to have had a significant impact on the EUR/USD exchange rate; however, they seem to have weakened the Japanese yen both vis-a-vis the U.S. dollar and the euro. In addition to these factors, the accounting scandals in the U.S. stock markets as well as fears of war and terrorism had a dampening effect on market sentiment, thus adding to the strain on the U.S. dollar. Measurement problems render it difficult to assess the role of euro area monetary policy and of European economic data. With a view to nonfundamental factors, we discuss the role of the trend-following behavior of agents in the foreign exchange market on the basis of a technical foreign exchange trading system used in practice. The buy and sell recommendations of such systems may also help explain the appreciation of the euro in the period in question. All in all, these fundamental and nonfundamental factors may explain the direction to which the EUR/USD exchange rate moved, but not the extent of this movement or the relative significance of these factors in determining the EUR/USD exchange rate in the period in question.