Economics of Foreign Exchange: Dollar Exchange Rate

The Real Exchange Rate of the Dollar 1973-1990 The real exchange rate of the dollar is usually estimated by the level of U.S. consumer prices in relation to an average of consumer prices in other nations. The average of prices of other nations is weighted by their trade shares and adjusted by dollar exchange rates. The graph in Box 7 shows an index (1973 = 100) of the real exchange rate of the U.S. dollar against the currencies of 10 major industrialized nations from 1973 to 1989. Most of the movement is a result of changes in nominal exchange rates. As you can see, the real exchange rate increased sharply from 1980 to 1985 and then fell between 1985 and 1988. In 1988, the real exchange rate increased again as interest rates increased, and then declined in 1989 and 1990. Despite the decline in the value of the dollar in 1985, the price of imports did not increase substantially at first. Empirical evidence suggests that import prices respond with a lag of up to two years to changes in exchange rates. Evidence indicates that the profit per unit of output increased for foreign suppliers to U.S. markets between 1980 and 1984 when the dollar appreciated. When the dollar began to depreciate, many foreign sellers apparently chose to get along with less profit per unit rather than raise prices significantly. In addition, many foreign currencies were tied to the dollar, and the dollar did not depreciate substantially against them. Over the period during which the dollar depreciated against the yen and the mark in the 1980s, it actually appreciated against the Korean won, thereby making Korean goods less expensive to U.S. buyers! Why did the dollar appreciate so much in the early 1980s, and why did it decline in 1985 and 1988? Like most prices, the price of the dollar responds to changes in influences on its demand and supply. A key factor that has influenced the dollar's price in recent years has been real interest rates in the United States relative to those in foreign nations. The high real interest rates that prevailed from 1981 to 1985 increased the demand for the dollar so that it could be used by foreigners to make investments in U.S. real and financial assets. The large budget deficit and Federal Reserve policies to reduce the rate of inflation in the early 1980s contributed to high real interest rates. Not surprisingly, policies in 1985 and 1986 that sharply lowered real interest rates resulted in marked depreciation of the dollar on international markets. The graph in Box 7 also shows the real interest-rate differential measured by the difference between U.S. real long-term interest rates and a weighted average of foreign real long-term interest rates. When the interest rate differential between the United States and foreign nations increases, the dollar typically becomes more attractive to hold. As the demand for it increases, so does the real exchange rate. As you can see from the graphs, movements in the interest rate differential between the United States and other nations are followed by similar movements in the real exchange rate of the dollar. In 1988 when short-term real interest rates began to rise again as the Fed began a contractionary monetary policy, the dollar began another upward climb. A booming U.S. economy in 1988 and early 1989 also contributed to increased import demand, putting upward pressure on the price of the dollar. By late 1989 as short-term interest rates fell somewhat and the U.S. economy began to slow down, there was downward pressure on the price of the dollar and the real exchange rate began to fall. As you know from your study of aggregate demand and aggregate supply analysis, an increase in the exchange rate of the dollar reduces aggregate demand, because it increases the price of our exports while decreasing the price of imports. It puts downward pressure on net export demand. The decrease in aggregate demand puts downward pressure on both the price level and real GNP. However, an increase in the exchange rate of the dollar also causes aggregate supply to increase by reducing the prices of imported inputs. The increase in aggregate supply puts downward pressure on the price level but puts upward pressure on real GNP. An increase in the real exchange rate therefore puts downward pressure on the price level but can either increase or decrease the equilibrium level of real GNP. Similarly, a decrease in the real exchange rate of the dollar will increase aggregate demand and decrease aggregate supply. Aggregate demand increases when the real exchange rate falls, because the demand for U.S. exports increases while domestic demand for imports falls. The increase in aggregate demand puts upward pressure on the price level and upward pressure on real GNP. Aggregate supply decreases because a decrease in the real exchange rate of the dollar increases the price of imported imports. The decrease in aggregate supply puts upward pressure on the price level but also puts downward pressure on equilibrium real GNP. Thus, a decrease in the exchange rate will put upward pressure on the price level but can either increase or decrease equilibrium real GNP.