Monday, October 22, 2007

How will the USD depreciation affect the US economy?

"What is the benefit of a depreciating USD? In particular, will it reduce interest in investing in US assets, as they will offer a lower return? And does it make the US better off?" - Catherine

I have already discussed the effects of the exchange rate on the current account elsewhere- see in particular this post. A lower exchange rate results in exports being relatively cheap and imports relatively expensive, and so tends to directly improve the current account balance.

On the capital account, the effects are less clear. First consider the static case: what is the effect of a low value of the USD on demand for USD denominated assets? To be precise, consider an asset that offers a fixed stream of future income payments, such as a US government bond. A lower exchange rate decreases the exchange-rate adjusted return on the bond, but it also decreases the exchange-rate adjusted price by the same percent amount, so the real returns to foreign asset holders should be independent of the exchange rate.

More importantly, the capital account is influenced by the dynamics of the exchange rate, particularly its expected future path. For example, if we expect the value of the USD to continue to weaken, then we have less incentive to buy USD-denominated assets, as we would then suffer a capital loss when the exchange rate falls. This may be self-fulfilling: the USD is expected to depreciate, so investors do not wish to hold USD assets, so the demand for USD falls, so the USD depreciates, as expected.

This self-fulfilling path has limits, however. We know that in the long run, the exchange rate tends to over-correct. Thus the further it falls, the more likely it is to increase in the coming years, making the purchasing of USD assets more inviting. Thus USD assets will eventually find buying support as investors start to believe that the USD is more likely to appreciate rather than depreciate. I'm not saying that we're at the point yet: any exchange rate investment decisions are risky, especially in the short run.

Regarding your final question, an exchange rate depreciation does not make the US better off. Yes, it helps the US economy to adjust to shocks (in this case a negative wealth shock), but it also makes USD asset holders and income earners worse off. They can no longer afford the same quantity of foreign-sourced consumption goods. In that sense, a currency depreciation makes Americans worse off.


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