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ESSAYS ON ISSUES TH E FEDERAL RESERVE BANK OF CHICAGO MARCH 1988 NUMBER 7 Chicago Fed Letter D ollar drop helps those w ho help themselves terms (based on 1982 prices) exports were up 10.3 percent (for the first nine months—the most recent data). Since its peak in 1985, the foreign ex change value of the dollar has dropped more than 50%. A fall that great should have dramatically reduced the deficit in U.S. international trade by now. It hasn’t. But imports also increased from 1986 levels. In 1987, the current dollar value of imports rose 10.7 percent from the previous year. Increased prices ac counted for much of the increase, but the real volume of imports for the January—September period was also up from a year ago—by 4.3 percent.1 The real trade deficit declined but the nominal deficit continued to increase. Instead, as of late 1987, the deficit in U.S. merchandise trade was running at a record rate, and ended the year in excess of $170 billion. Why? which the dollar has stayed strong. These include Canada (our largest trading partner) and many newly in dustrializing countries of Latin Amer ica and the Pacific rim. According to this view, the dollar has not dropped as much as is commonly thought. While this explanation has considerable merit, most of the debate over how much the dollar has, or has not, depre ciated misses an important element. Dollar prices of imports to the U.S. have increased substantially during the past A depreciation in the exchange value of the dollar should increase the dollar price of U.S. imports. In response, do mestic consumers should purchase fewer of those now more expensive im ports. If the quantity purchased (“real imports”) declines by a greater per centage than the price increased, then the total nominal or “current dollar” value of imports declines. So, a weaker dollar should reduce the total dollar value of imports. On the other side of the theoretical coin, U.S. exports become cheaper in terms of the stronger foreign currencies. Foreign demand for U.S. goods in creases as does the dollar value of the foreign purchases. In theory, then, the value of U.S. exports increases, the dollar value of U.S. imports decreases, and the trade deficit shrinks. Where theory fears to tread Any economist would hedge that ex planation with the Latin catch, ceteris paribus, or “other things remaining the same.” And, that is the catch. Other things have not remained the same. True, the value and the volume of U.S. exports have turned upward. During 1987 the current dollar value of mer chandise exports was 11.5 percent greater than during 1986, and in real Beyond the “ J” curve There have been a number of attempts to make sense out of the situation. The technical phenomenon called the “J ” curve is often cited. But it has been pushed beyond its short-term explana tory limits and sheds little light on the longer-term failure to close the trade gap significantly. Another explanation points to the in creasing volume of U.S. trade with countries having currencies against year. But, what really counts is the relationship between import prices and prices for domestically produced com petitive goods. A falling dollar can not itself close the trade gap. More im portant is how importers, exporters, and domestic producers price their goods, in terms of the falling dollar. These exchange rate/price relationships have received little attention, yet they are basic in measuring the impact of an exchange rate change on countries’ real trade balances. Relative prices: sectors Tales of three A depreciating dollar, which makes imports more expensive, has little effect in the marketplace if prices for domes tic substitutes are also increasing and imports retain a substantial price ad vantage. In some sectors of the econ omy, U.S. producers have raised their prices as import prices have increased. We should not be too surprised that the value and volume of imports continues to increase in these sectors. The trends represented in Figure 1 support the contention that the declin ing dollar is having some impact on import trade. In particular, the dollar values of automotive and consumer durables imports, in real terms, have leveled off and even declined slightly since mid-1986. index, 1980Q 1 = 100 1DU I dolla ' peak Im p ort prices D o m e stic — prices 140 1° 0 Im p o rt prices re la tiv e to d o m es tic prices 100 _____________ ___ ,____ ___ 80 _____ I— I__ I__ I__ I__ I__ I__ I__ I__ I__ l_J__ I__ l— 1__1__ 1__ 1__ 1 1980 1981 1982 1983 1984 1 1 1 1985 1 1 1 1 1986 1 1__ 1__ l _ l ______________ 1987 But, Figure 1 shows quite a different picture with respect to capital equip ment, which accounts for more than one-fifth of the total value of merchan dise imports. Gains in real capital equipment imports appeared to slow in the last half of 1986 only to increase sharply again during recent quarters. Let’s examine the trends in relative prices of imports as compared with do mestic producer prices for these three major categories, to see why gener alizations fail to explain the slow re sponse to the declining dollar. The tale of autos During the 1979-1980 period rapidly advancing oil prices boosted demand for fuel-efficient foreign autos, resulting in upward pressure on prices. Then, the Japanese government began to limit the number of cars shipped to the United States in April 1981—to parry U.S. threats of import restrictions. To maintain the dollar value of their sales Japanese auto-makers shifted the ex port product-mix toward more expen sive models. Thus, despite the appre ciation in the exchange value of the dollar from mid-1980 to early-1985, auto import prices continued to in crease (see Figure 2). As prices for foreign autos went up, U.S. auto producers elected to increase prices and restore profits rather than attempt to recover market share from foreign producers. Throughout the period 1980 to early 1985 prices of do mestic and imported cars moved up ward virtually in “lock-step.” As a result, the relative prices of imports to domestics remained steady. The sharp weakening of the dollar in early 1985 began to show up in an ac celeration in import prices relative to domestic prices later that year. But, despite the relative reduction in U.S. car prices, foreign producers have con tinued to increase market share, sug gesting that U.S. producers have not yet become competitive on the non price component of the auto market. The tale of consumer durables A somewhat different and thankfully more favorable picture emerges for prices of imported and domestic con sumer durable goods, such as consumer electronics, (see Figure 3). As the dol lar strengthened during the first half of the 1980s the dollar price of imports declined. Later, as the dollar weak ened, the dollar price of imports rose. ' . . Si: . '• "i . the ratio in 1980, before the appreci ation of the dollar began.12 index, 1980 Q1= 100 dolla \p eak ^ ' |——m D o m e stic prices — 1 o0 ...... ----------------------- *--------------— Im p ort prices ■^ 80 Im p o rt prices re la tiv e to d o m es tic prices 60 --------- 1— I— I__ I__ I__ I__ l__ 1__ 1__ 1__ 1__ 1__ i I l__ 1 1980 1981 1982 1983 i i i 1984 Domestic prices, on the other hand, moved upward during the period. The decline in the relative-price ratio of imports to domestic consumer dura bles indicates that during the first half of the 1980s the U.S. competitive posi tion deteriorated. Declining import prices reduced U.S. competitiveness and increases in domestic producer prices compounded the problem. Following the dollar’s peak and subse quent decline in 1985 the dollar price of imported consumer durables in creased, more than offsetting the con tinued increase in domestic prices. Thus, from the relative price ratio we see an improvement in the competitive position of the United States for con sumer durable goods (see Figure 3). As expected, the recent decline in the exchange value of the dollar has in creased import prices for consumer du rables. But, because of concurrent increases in domestic prices, the impact of higher import prices has not been as large as would otherwise be expected because it is the relative import/domestic price relationship that is important. The tale of capital equipment The data presented in Figure 4 indicate that dollar prices for imported capital equipment, such as machine tools, fol Moral of the tales The potential price effects on trade re sulting from an exchange rate change cannot be looked at in isolation from the domestic price developments for competing goods. So long as domestic producers in search of improved profit margins increase prices and thus offset the potential gains in market share from the dollar depreciation, it will be difficult to reestablish a strong compet itive position for U.S. goods in the do mestic market against their foreign counterparts. In short, unless U.S. producers realign their priorities, a sig nificant reduction in the deficit by re ducing imports is not in the cards. 1 __ 1__ i__ 1__ i__ i__ i__ 1__ i__ i__ i__ 1______________ 1985 1986 1987 low the expected path during periods of strengthening and weakening dollars—very much the path traced by consumer durables. The amplitude of the movement was substantially larger, however. During the period when the dollar was rising (1980-Q3 to 1985-Qj) the price index for imported capital equipment declined nearly 15 percent. At the same time, however, domestic capital equipment prices rose 21 per cent. In terms of price competitiveness the decline in the position of domestic capital equipment was substantial. The ratio of import prices to domestic prices fell by more than 35 percent during this period (by comparison, the decline in the comparable ratio for consumer durables was 20 percent). To make matters worse, with the dollar now weaker, U.S. price competitiveness in capital equipment has not improved appreciably. The index of dollar prices for capital equipment imports has in creased since the dollar began to de preciate in early 1985—by 13 percent through the third quarter of 1987. But, domestic prices continued to increase, helping to offset the price incentive for U.S. buyers to substitute domestic pro ducts for the higher priced imports. The net effect is that by the third quarter of 1987 the ratio of import prices to domestic prices for capital equipment was still 27 percent below —Jack L. Hervey 1 T h e d e p reciatio n o f the d o llar has boosted im p o rt prices. A ccording to U .S. D e p a rtm e n t o f L a b o r estim ates, in the fo urth q u a rte r o f 1987 im p o rt prices w ere, on av erag e, n early 15 p ercen t above a year-ago. E x p o rt prices, on the o th er h a n d , w ere up a b o u t 7 percent. A fact th a t m ust be kep t in m ind th ro u g h o u t is th a t in the absence o f the d o llar d e p reciatio n the tra d e deficit w ould have been la rg e r th a n th a t recorded. 2 T h e ratio o f im p o rt prices to dom estic prices for consum er d u rab les in the thirdq u a rte r o f 1987 was only 9 p ercen t below the 1980 figure. F or autos the ratio m oved in favor o f dom estic p roducers w ith the im p o rt-to -d o m estic ratio up 10 percent. K arl A. Scheld, Senior Vice President and D irector o f R esearch; David R. A llardice, Vice P resident and Assistant D irector of R esearch; E dw ard G. N ash, E ditor. C hicago Fed L etter is published m onthly by the Research D ep artm en t of the Federal Reserve Bank o f C hicago. T h e views expressed are the au th o rs’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Articles m ay be rep rin ted if the source is credited and the R esearch D ep artm en t is provided with copies o f the reprints. C hicago Fed L etter is available w ithout charge from the Public Inform ation C enter, Federal Reserve Bank of C hicago, P.O . Box 834, C hicago, Illinois 60690, or telephone (312) 322-511 1. ISSN 0895-0164 Manufacturing activity in the nation rose 0.2 percent in December after two months of solid gains, according to the Federal Reserve Board’s Index. Declines in transportation equipment and machinery production accounted for much of the overall slowdown. The national pattern of two strong months followed by a weak December was reflected in Midwest manufacturing activity. Because of the importance of transportation equipment and machinery in the industrial structure of the Mid west, the Midwest Manufacturing Index declined 1.2 percent in December. Pri mary metals, which has been a major factor in the acceleration of manufacturing activity throughout the nation during the last year, edged up by 0.1 percent in the Midwest during December. Chicago Fed Letter F E D E R A L R E S E R V E BAN K O F C H IC A G O P u b lic In fo rm a tio n C en ter P .O . Box 834 C h ica g o , Illin o is 60690 (312) 322-5111 N O T E : T h e M M I is a com posite index o f 15 m an u factu rin g industries and is constructed from a w eighted com bination o f m onthly hours worked, and kilow att hours d a ta . See “M idw est M an u factu rin g Index: T h e C hicago F ed ’s new regional econom ic in d icato r,” Economic Perspectives, F ederal Reserve Bank o f Chicago, Vol. X I, No. 5, S ep tem b er/O cto b er, 1987. T h e U n ited States represents the F ederal Reserve B o ard ’s In d ex of In d u strial P roduction, M anufacturin g .
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