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political environment.
Individuals
worldwide can hold dollars with few
political or economic risks, as compared
to the other world currencies.
One would think that international
investors must have some limit to their
total holdings of dollar assets and, consequently, that a U.S. current-account
deficit cannot persist indefinitely. In a
growing world economy, however,
asset holders will not worry about the
absolute amount of dollar-denominated
assets they hold, but will consider
instead the proportion of their portfolio
denominated
in dollars. If foreign portfolios are growing, asset demand for
dollars can continue to grow, and the
United States can run a persistent
current-account
deficit. By this criterion, therefore, the dollar is "overvalued" if the current rate at which
foreigners are accumulating
dollardenominated
assets exceeds their longterm desired rate.
Economists do not know enough
about the determinants
of portfolio

demands for dollar-denominated
assets
to determine when the U.S. currentaccount deficits will saturate foreign
asset demands for dollars. Some recent
projections of the scale of U.S. indebtedness relative to various measures of
wealth and GNP suggest that in 10 or
20 years the proportion of dollardenominated
assets in foreign portfolios will be high by historic standards."
Moreover, as interest payments to
foreigners grow, becoming an increasing share of the total current-account
deficit, the portion of the currentaccount deficit attributable
to the trade
deficit must eventually shrink. Otherwise, U.S. liabilties to foreigners eventually would exceed foreigners' willingness to hold dollar-denominated
assets. A dollar depreciation,
therefore,
will be necessary to facilitate the
smaller trade deficit. Unfortunately,
we
cannot pinpoint either the size or the
timing of such a depreciation.

Is the Dollar Overvalued?

the factors underlying foreign-currency
demands and supplies today are not
sustainable
in the long term. The practical difficulties of making such judgments are great.
If policymakers wish to alter the
exchange rate in a fundamental
manner, they must alter the economic
environment
in which the exchange
rate exists by changing monetary and
fiscal policies. Often this involves a
trade-off with other policy objectives.
Expanding the money supply to encourage dollar depreciation,
for example,
can risk higher inflation. Moreover,
because each exchange rate involves
two currencies, a coordinated effort
seems necessary to limit exchange rate
movements. Otherwise, one nation's
gain could become another's loss.
We adopted floating exchange rates
in 1973 because of the enormous difficulties in identifying and maintaining
"equilibrium"
exchange rates. While
the current exchange rate system is not
perfect, it has yet to be shown inferior
to its predecessor.

There are many difficulties in determining if an exchange rate is either
overvalued or at its long-term equilibrium value. Generally, exchange rates
are "overvalued"
only in the sense that

5. See Paul R. Krugman,
"Is The Strong Dollar
Sustainable?"
Paper prepared for a Federal
Reserve Bank of Kansas City conference at Jackson Hole, Wyoming, August 21-30, 1985; and Stephen N. Marris, "The Decline and Fall of the Dollar: Some Policy Issues," Brookings Papers on
Economic Activity, 1:1985, pp. 237-44.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

ISSN 042il- 1276

ECONOMIC
COMMENTARY

Address Correction Requested: Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
PO. Box 6387. Cleveland, OH 441Ol.

A Correct Value
for the Dollar?
by Owen F. Humpage &
Nicholas V. Karamouzis

-ERtODtCALS
The dollar's rapid appreciation in
foreign-exchange
markets between mid1980 and February 1985 greatly
reduced the international
competitiveness of many U.S. industries,
contributed
to unemployment
in the
trade-sensitive
sectors of the economy,
and heightened calls for protectionist
legislation. Although the dollar has
since depreciated in foreign-exchange
markets, many analysts contend that it
remains "overvalued"
or "too high."
Complaints about the performance of
the dollar in recent years have renewed
interest among policymakers
in managing exchange rates through more frequent exchange-market
intervention.
Some analysts advocate alternative exchange-rate systems which, in their
view, would limit the ability of exchange rates to deviate from their socalled equilibrium values.
There is considerable disagreement
and misunderstanding
about what the
term "overvalued"
means. It implies
that the present value of the dollar is
incorrect in some sense, that it is unsustainable, and that the observer knows
the correct, or equilibrium,
rate. In this
Economic Commentary, we discuss various interpretations
of "equilibrium"
and of "overvalued"
exchange rates.

Equilibrium and the
Foreign Exchange Market
An exchange rate is the price of one
nation's currency in terms of another's.
Like all prices, exchange rates are
determined by the laws of supply and

Material may be reprinted
provided that the
source is credited. Please send copies of reprinted
materials
to the editor.

january 1, 1986

Federal Reserve Bank of Cleveland

Owen F. Humpage is an economist with the Federal Reserve Bank of Cleveland. Nicholas V.
Karamouzis is an assistant professor in the
Department of Economics at Case Western Reserve
University in Cleveland, Ohio.
The views stated herein are those of the authors
and not necessarily those of the Federal Reserve
Bank of Clevela nd or of the Board of Governors of
the Federal Reserve System.

demand. A currency appreciates in the
foreign-exchange
market when the
quantity demanded exceeds the quantity supplied. Individuals acquire foreign currency primarily because they
wish to obtain something else with it.
They might wish to purchase foreign
goods and services, or to invest in foreign plants and equipment, or to hold a
foreign financial asset. Consequently,
the factors that underlie the demand
for these items underlie the demand for
foreign currency. I
There are many such factors, but differences in prices, income levels, and
interest rates among nations seem to
determine exchange rates most directly.
Prices, income levels, and interest
rates, in turn, are influenced by monetary and fiscal policies, by technological
developments,
and by other variables.
Often the connections between these
economic variables and exchange rates
are complex and the relative importance of individual factors can change."
It is also important to remember that
exchange markets are forward looking;
participants
adjust their exchange-rate
quotes when expectations
of future
economic and political events change.
Economists define an equilibrium
price as that which, at a given time,
balances quantities demanded with
quantities supplied in an unrestricted
market. In this sense, the dollar is seldom overvalued. Exchange-market
traders around the world continually
assess market information and take

actions that move exchange rates minute by minute to quickly offset emerging or perceived imbalances in supply
and demand.
Of course, exchange-market
analysts
have a more stable view of equilibrium
in mind when they label an exchange
rate overvalued. Because of the great difficulty in specifying all the factors underlying the long-term equilibrium,
exchange-market
analysts usually base
their assessment
of what constitutes
an equilibrium exchange rate on a
limited set of factors that they regard
as the "fundamental"
determinants
of
exchange rates. This set usually includes the current account and relative
rates of inflation." If exchange-market
developments push exchange rates away
from the levels dictated by these socalled fundamentals,
then the exchange
rates are considered overvalued or
undervalued,
as the case may be, even
though they are equating quantities of
currencies demanded and supplied.
While exchange-market
analysts
might define exchange-rate
equilibrium
in terms of the trade account, or in
terms of relative inflation rates, they do
not expect the rate to move continually
along such an equilibrium path. Economists have observed that prices and
trade-account
transactions
adjust
slowly to economic shocks and policy
changes, while exchange rates adjust
quickly. Consequently,
following an
unexpected event, or a change in the
market's expectations,
exchange rates
can overshoot these equilibrium paths.
Often, therefore, overvalued exchange
rates are consistent with the efficient
operation of the exchange market. In

1. Because one purchases
a foreign currency
with dollars, the demand for a foreign currency
creates a supply of dollars.

3. The current account measures trade in goods
and services and unilateral
transfers.
Some analysts focus only on trade flows.

2. See Owen F. Humpage and Nicholas V. Karamouzis, "The Dollar in the Eighties,"
Economic
Commentary, Federal Reserve Bank of Cleveland,
September
1, 1985.

addition, speculation can push
exchange rates off these equilibrium
paths for short periods of time. The
important point is that these deviations
are transitory.
The Long-Run "Fundamentals"
When exchange-market analysts speak
of the fundamentals, such as the current account or inflation differentials
among countries, they presume to fully
understand the linkages among these
fundamentals and other economic variables, and to understand their quantitative significance for exchange rates.
Unfortunately, several recent studies
have indicated how limited our knowledge of exchange-rate determination is.
One study showed that predictions
from major economic models of exchange rates generally were no more accurate than a simple guess that tomorrow's exchange rate will equal today's
rate.' Other empirical studies of exchange rates often produce relationships
among the variables that are not statistically significant or that are contrary to
accepted theories. Although such results
could reflect statistical problems. they
suggest that we do not know enough
about the behavior of exchange rates to
pinpoint their "fundamental" determinants, or "equilibrium" values.
Despite the many unsuccessful
attempts to model exchange-rate behavior, many analysts continue to judge
the appropriateness of exchange rates
on the basis of certain factors that theory suggests could be fundamental
determinants of the long-term value of
exchange rates. Below, we discuss
three such factors: relative inflation
rates, the current accounts, and asset
preferences for currencies.

4. See Richard A. Meese and Kenneth S. Rogoff.
"Empirical
Exchange Models of the Seventies: Do
they Fit Out-of-Sample?"
Journal 0/ International
Economics. Vol. 14,no. 112(February 1983),p.
p

3-24.

Purchasing Power Parity
The purchasing power parity theorem
(PPP) maintains that relative rates of
inflation determine long-term equilibrium exchange-rate movements. According to PPP, exchange rates adjust so
that a dollar. after conversion to a
foreign-currency equivalent, buys as
much abroad as it does in the United
States. If inflation in the United States
is higher than in Germany, German
goods will gain a competitive price
advantage over U.S. goods in world
markets. As consumers buy more German goods and services, demand for
German marks increases, and the mark
appreciates in exchange markets. The
mark's appreciation raises the foreigncurrency price of German goods and
lowers the mark price of non-German
goods. According to PPP, the mark
appreciates until it completely offsets
the German price advantage.
Chart 1 CPI Adjusted Trade Weighted
Dollar 1973-1985
Inde-,:;x~
March

150

......,

1979= 100

140
130
120

80
70~~~~~~~~~~~~~~
1974 1976 1978 1980 1982 1984
SOURCE: Board
Reserve System.

of Governors

of the Federal

PPP allows that certain exchangemarket developments, notably capital
flows, can push exchange rates away
from their PPP path for short periods of
time. These deviations will not persist,
according to PPP, because they will
alter the relative prices of traded goods
among countries and again create
incentives to change trading patterns
so as to return exchange rates to their
PPP paths.

Although the logic of the PPP theorem is attractive, experience shows
that exchange rates often deviate from
their PPP path by large amounts, and
for long periods of time. Chart 1 shows
movements in the real trade-weighted
dollar. When PPP holds, the real tradeweighted dollar should equal 100, its
base-year value. By this measure then,
the dollar has deviated from PPP for
four years and by as much as 46 percent in February 1985. The patterns
suggest that the mechanisms to ensure
a return to PPP might take decades,
rather than months, to work through.
Many technical difficulties hamper
the application of PPP. Unless one can
obtain good estimates of the equilibrium exchange rates with PPP, one
can never judge existing exchange
rates as overvalued or undervalued.
One major difficulty in attempting to
apply PPP is that the price indexes
used to calculate PPP values differ
among countries. Consequently, similar
price pressures in countries using differently constructed price indexes
could produce different responses in
each price index. The price indexes
then would not provide a reliable guide
to exchange-rate movements.
A second problem with applying PPP
is that it should be measured against a
base period characterized by equilibrium. Usually base periods are chosen
because the current account or trade
account was in balance. Often there is
more than one possible base period, and
the resulting PPP path will differ
depending on which is chosen. If mid1977 is chosen as the base period for
the PPP calculation, the dollar in February 1985 was overvalued relative to
the mark by 81 percent. If mid-1981 is
chosen as the base year, the dollar was
overvalued by only 43 percent.
Another problem with defining the
equilibrium exchange rate solely in
terms of inflation differentials is that
other factors can alter the equilibrium
exchange rate. Productivity differentials, technological changes, changes in
tastes, and changes in trade laws can

all alter the relationship between relative price changes among countries and
exchange-rate movements independent
of the inflation process. Assume, for
example, that an oil-exporting country
raises oil prices. The oil-exporting
country would experience a surplus,
while the oil-importing countries would
experience a deficit. Even if inflation
differentials between these countries
did not change, we would expect the
currencies of the oil-importing countries to depreciate relative to the currency of the oil-exporting country. The
depreciation would reflect the need of
the oil importers to sell more goods to
pay for the higher-priced oil.
The Current-Account Balance
Many exchange-market analysts avoid
the problems associated with PPP by
focusing directly on the current
account. According to this criterion, the
equilibrium exchange rate will maintain balance in the current account
after allowing for the short-term effects
of business cycles and the distortions of
trade barriers. Nations running currentaccount deficits absorb more resources
through private consumption, through
investment, and through government
deficits than they produce. Since
incomes reflect the value of production,
nations running current-account deficits absorb in excess of their income and
finance the difference with foreign savings. Nations that persistently run
current-account deficits eventually
become debtor nations; their liabilities
to foreigners eventually exceed their
holdings of foreign assets.
Current-account deficits can persist
only as long as creditor nations will
finance the excess absorption by
acquiring claims on the deficit countries. If the world's willingness to
acquire claims on a deficit country is
limited, then current-account imbalances eventually produce adjustments in
exchange rates, prices and incomes
that work to correct the currentaccount imbalances. Deficit countries,
for example, should experience depreciating currencies that work to reduce
imports and to increase exports.

By this criterion, only exchange rates
that maintain a balance in a nation's
current account are sustainable in the
long term. With allowances for business cycles and trade barriers, an
exchange rate that permits a currentaccount deficit to persist is overvalued
and one that permits a current-account
surplus to persist is undervalued.
While one might apply the currentaccount criterion to a trade-weighted
average exchange rate, one cannot use
the criterion on a currency-by-currency
basis. Assume that the United States
has a $30 billion deficit in trade with
Japan and a $30 billion surplus in trade
with Germany, while Germany has a
$30 billion trade surplus with Japan.
There is no reason for the exchange
rates among these currencies to
change, since for each currency the
overall quantities demanded and supplied balance.
The current-account deficit provided
a reasonable guide to the trade-weighted
dollar in the early 1970s. In 1970-71 and
again in 1977-78, the United States
incurred current-account deficits, and
the dollar depreciated. This suggested
that the dollar was moving to a new
equilibrium consistent with a currentaccount balance. More recently, however, the United States has experienced
record current-account deficits with the
dollar showing no tendency to depreciate.
The current-account balance and
PPP define equilibrium exchange rates
in terms of a supply and demand model
that reflects only trade in goods and
services and transfer payments. The
difficulty with these approaches is that
they do not permit individuals to hold
dollar-denominated assets for portfolio
considerations. They do not recognize
that private capital flows, responding
to preferences for financial assets denominated in foreign currencies, influence the long-term value of the dollar.

Portfolio Demand For Dollars
The failure of PPP and the current
account to explain exchange-rate
movements has led many researchers
to investigate asset preferences for dollars. According to this approach, international investors hold in their portfolios assets denominated in many currencies. Such diversification affords them
protection against losses associated
with political events or with unforeseeable exchange-rate movements. The
dollar exchange rates and interest rates
adjust to ensure that the supply of
dollar-denominated assets provided
through the current-account deficit
equals foreigners' demands for dollardenominated assets.
According to this view, a currentaccount deficit can persist if the quantity of currency being supplied through
a current-account deficit matches the
quantities demanded by private international investors. The dollar is overvalued only if the current-account
deficit supplies more dollars to the
exchange market than private asset
demands can absorb.
Central banks can support this situation for a limited time by intervening in
the foreign exchange market and purchasing the excess currency. However,
the quantity of international reserves
that these central banks have at their
disposal for purchasing the overabundant currency ultimately limits such
intervention. Consequently, if a nation
is systematically losing international
reserves, its currency would seem to be
overvalued.
The size of the sustainable currentaccount deficit depends on the attractivenessof a nation's currency to international investors. The U.S. dollar is
an important currency in world markets.
Individuals and firms hold dollardenominated assets as a store of wealth
and to facilitate trade. This role of the
dollar emanates from the breadth of the
U.S. financial market and from the relative stabililty of the U.S. economic and

addition, speculation can push
exchange rates off these equilibrium
paths for short periods of time. The
important point is that these deviations
are transitory.
The Long-Run "Fundamentals"
When exchange-market analysts speak
of the fundamentals, such as the current account or inflation differentials
among countries, they presume to fully
understand the linkages among these
fundamentals and other economic variables, and to understand their quantitative significance for exchange rates.
Unfortunately, several recent studies
have indicated how limited our knowledge of exchange-rate determination is.
One study showed that predictions
from major economic models of exchange rates generally were no more accurate than a simple guess that tomorrow's exchange rate will equal today's
rate.' Other empirical studies of exchange rates often produce relationships
among the variables that are not statistically significant or that are contrary to
accepted theories. Although such results
could reflect statistical problems. they
suggest that we do not know enough
about the behavior of exchange rates to
pinpoint their "fundamental" determinants, or "equilibrium" values.
Despite the many unsuccessful
attempts to model exchange-rate behavior, many analysts continue to judge
the appropriateness of exchange rates
on the basis of certain factors that theory suggests could be fundamental
determinants of the long-term value of
exchange rates. Below, we discuss
three such factors: relative inflation
rates, the current accounts, and asset
preferences for currencies.

4. See Richard A. Meese and Kenneth S. Rogoff.
"Empirical
Exchange Models of the Seventies: Do
they Fit Out-of-Sample?"
Journal 0/ International
Economics. Vol. 14,no. 112(February 1983),p.
p

3-24.

Purchasing Power Parity
The purchasing power parity theorem
(PPP) maintains that relative rates of
inflation determine long-term equilibrium exchange-rate movements. According to PPP, exchange rates adjust so
that a dollar. after conversion to a
foreign-currency equivalent, buys as
much abroad as it does in the United
States. If inflation in the United States
is higher than in Germany, German
goods will gain a competitive price
advantage over U.S. goods in world
markets. As consumers buy more German goods and services, demand for
German marks increases, and the mark
appreciates in exchange markets. The
mark's appreciation raises the foreigncurrency price of German goods and
lowers the mark price of non-German
goods. According to PPP, the mark
appreciates until it completely offsets
the German price advantage.
Chart 1 CPI Adjusted Trade Weighted
Dollar 1973-1985
Inde-,:;x~
March

150

......,

1979= 100

140
130
120

80
70~~~~~~~~~~~~~~
1974 1976 1978 1980 1982 1984
SOURCE: Board
Reserve System.

of Governors

of the Federal

PPP allows that certain exchangemarket developments, notably capital
flows, can push exchange rates away
from their PPP path for short periods of
time. These deviations will not persist,
according to PPP, because they will
alter the relative prices of traded goods
among countries and again create
incentives to change trading patterns
so as to return exchange rates to their
PPP paths.

Although the logic of the PPP theorem is attractive, experience shows
that exchange rates often deviate from
their PPP path by large amounts, and
for long periods of time. Chart 1 shows
movements in the real trade-weighted
dollar. When PPP holds, the real tradeweighted dollar should equal 100, its
base-year value. By this measure then,
the dollar has deviated from PPP for
four years and by as much as 46 percent in February 1985. The patterns
suggest that the mechanisms to ensure
a return to PPP might take decades,
rather than months, to work through.
Many technical difficulties hamper
the application of PPP. Unless one can
obtain good estimates of the equilibrium exchange rates with PPP, one
can never judge existing exchange
rates as overvalued or undervalued.
One major difficulty in attempting to
apply PPP is that the price indexes
used to calculate PPP values differ
among countries. Consequently, similar
price pressures in countries using differently constructed price indexes
could produce different responses in
each price index. The price indexes
then would not provide a reliable guide
to exchange-rate movements.
A second problem with applying PPP
is that it should be measured against a
base period characterized by equilibrium. Usually base periods are chosen
because the current account or trade
account was in balance. Often there is
more than one possible base period, and
the resulting PPP path will differ
depending on which is chosen. If mid1977 is chosen as the base period for
the PPP calculation, the dollar in February 1985 was overvalued relative to
the mark by 81 percent. If mid-1981 is
chosen as the base year, the dollar was
overvalued by only 43 percent.
Another problem with defining the
equilibrium exchange rate solely in
terms of inflation differentials is that
other factors can alter the equilibrium
exchange rate. Productivity differentials, technological changes, changes in
tastes, and changes in trade laws can

all alter the relationship between relative price changes among countries and
exchange-rate movements independent
of the inflation process. Assume, for
example, that an oil-exporting country
raises oil prices. The oil-exporting
country would experience a surplus,
while the oil-importing countries would
experience a deficit. Even if inflation
differentials between these countries
did not change, we would expect the
currencies of the oil-importing countries to depreciate relative to the currency of the oil-exporting country. The
depreciation would reflect the need of
the oil importers to sell more goods to
pay for the higher-priced oil.
The Current-Account Balance
Many exchange-market analysts avoid
the problems associated with PPP by
focusing directly on the current
account. According to this criterion, the
equilibrium exchange rate will maintain balance in the current account
after allowing for the short-term effects
of business cycles and the distortions of
trade barriers. Nations running currentaccount deficits absorb more resources
through private consumption, through
investment, and through government
deficits than they produce. Since
incomes reflect the value of production,
nations running current-account deficits absorb in excess of their income and
finance the difference with foreign savings. Nations that persistently run
current-account deficits eventually
become debtor nations; their liabilities
to foreigners eventually exceed their
holdings of foreign assets.
Current-account deficits can persist
only as long as creditor nations will
finance the excess absorption by
acquiring claims on the deficit countries. If the world's willingness to
acquire claims on a deficit country is
limited, then current-account imbalances eventually produce adjustments in
exchange rates, prices and incomes
that work to correct the currentaccount imbalances. Deficit countries,
for example, should experience depreciating currencies that work to reduce
imports and to increase exports.

By this criterion, only exchange rates
that maintain a balance in a nation's
current account are sustainable in the
long term. With allowances for business cycles and trade barriers, an
exchange rate that permits a currentaccount deficit to persist is overvalued
and one that permits a current-account
surplus to persist is undervalued.
While one might apply the currentaccount criterion to a trade-weighted
average exchange rate, one cannot use
the criterion on a currency-by-currency
basis. Assume that the United States
has a $30 billion deficit in trade with
Japan and a $30 billion surplus in trade
with Germany, while Germany has a
$30 billion trade surplus with Japan.
There is no reason for the exchange
rates among these currencies to
change, since for each currency the
overall quantities demanded and supplied balance.
The current-account deficit provided
a reasonable guide to the trade-weighted
dollar in the early 1970s. In 1970-71 and
again in 1977-78, the United States
incurred current-account deficits, and
the dollar depreciated. This suggested
that the dollar was moving to a new
equilibrium consistent with a currentaccount balance. More recently, however, the United States has experienced
record current-account deficits with the
dollar showing no tendency to depreciate.
The current-account balance and
PPP define equilibrium exchange rates
in terms of a supply and demand model
that reflects only trade in goods and
services and transfer payments. The
difficulty with these approaches is that
they do not permit individuals to hold
dollar-denominated assets for portfolio
considerations. They do not recognize
that private capital flows, responding
to preferences for financial assets denominated in foreign currencies, influence the long-term value of the dollar.

Portfolio Demand For Dollars
The failure of PPP and the current
account to explain exchange-rate
movements has led many researchers
to investigate asset preferences for dollars. According to this approach, international investors hold in their portfolios assets denominated in many currencies. Such diversification affords them
protection against losses associated
with political events or with unforeseeable exchange-rate movements. The
dollar exchange rates and interest rates
adjust to ensure that the supply of
dollar-denominated assets provided
through the current-account deficit
equals foreigners' demands for dollardenominated assets.
According to this view, a currentaccount deficit can persist if the quantity of currency being supplied through
a current-account deficit matches the
quantities demanded by private international investors. The dollar is overvalued only if the current-account
deficit supplies more dollars to the
exchange market than private asset
demands can absorb.
Central banks can support this situation for a limited time by intervening in
the foreign exchange market and purchasing the excess currency. However,
the quantity of international reserves
that these central banks have at their
disposal for purchasing the overabundant currency ultimately limits such
intervention. Consequently, if a nation
is systematically losing international
reserves, its currency would seem to be
overvalued.
The size of the sustainable currentaccount deficit depends on the attractivenessof a nation's currency to international investors. The U.S. dollar is
an important currency in world markets.
Individuals and firms hold dollardenominated assets as a store of wealth
and to facilitate trade. This role of the
dollar emanates from the breadth of the
U.S. financial market and from the relative stabililty of the U.S. economic and

political environment.
Individuals
worldwide can hold dollars with few
political or economic risks, as compared
to the other world currencies.
One would think that international
investors must have some limit to their
total holdings of dollar assets and, consequently, that a U.S. current-account
deficit cannot persist indefinitely. In a
growing world economy, however,
asset holders will not worry about the
absolute amount of dollar-denominated
assets they hold, but will consider
instead the proportion of their portfolio
denominated
in dollars. If foreign portfolios are growing, asset demand for
dollars can continue to grow, and the
United States can run a persistent
current-account
deficit. By this criterion, therefore, the dollar is "overvalued" if the current rate at which
foreigners are accumulating
dollardenominated
assets exceeds their longterm desired rate.
Economists do not know enough
about the determinants
of portfolio

demands for dollar-denominated
assets
to determine when the U.S. currentaccount deficits will saturate foreign
asset demands for dollars. Some recent
projections of the scale of U.S. indebtedness relative to various measures of
wealth and GNP suggest that in 10 or
20 years the proportion of dollardenominated
assets in foreign portfolios will be high by historic standards."
Moreover, as interest payments to
foreigners grow, becoming an increasing share of the total current-account
deficit, the portion of the currentaccount deficit attributable
to the trade
deficit must eventually shrink. Otherwise, U.S. liabilties to foreigners eventually would exceed foreigners' willingness to hold dollar-denominated
assets. A dollar depreciation,
therefore,
will be necessary to facilitate the
smaller trade deficit. Unfortunately,
we
cannot pinpoint either the size or the
timing of such a depreciation.

Is the Dollar Overvalued?

the factors underlying foreign-currency
demands and supplies today are not
sustainable
in the long term. The practical difficulties of making such judgments are great.
If policymakers wish to alter the
exchange rate in a fundamental
manner, they must alter the economic
environment
in which the exchange
rate exists by changing monetary and
fiscal policies. Often this involves a
trade-off with other policy objectives.
Expanding the money supply to encourage dollar depreciation,
for example,
can risk higher inflation. Moreover,
because each exchange rate involves
two currencies, a coordinated effort
seems necessary to limit exchange rate
movements. Otherwise, one nation's
gain could become another's loss.
We adopted floating exchange rates
in 1973 because of the enormous difficulties in identifying and maintaining
"equilibrium"
exchange rates. While
the current exchange rate system is not
perfect, it has yet to be shown inferior
to its predecessor.

There are many difficulties in determining if an exchange rate is either
overvalued or at its long-term equilibrium value. Generally, exchange rates
are "overvalued"
only in the sense that

5. See Paul R. Krugman,
"Is The Strong Dollar
Sustainable?"
Paper prepared for a Federal
Reserve Bank of Kansas City conference at Jackson Hole, Wyoming, August 21-30, 1985; and Stephen N. Marris, "The Decline and Fall of the Dollar: Some Policy Issues," Brookings Papers on
Economic Activity, 1:1985, pp. 237-44.

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ECONOMIC
COMMENTARY

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A Correct Value
for the Dollar?
by Owen F. Humpage &
Nicholas V. Karamouzis

-ERtODtCALS
The dollar's rapid appreciation in
foreign-exchange
markets between mid1980 and February 1985 greatly
reduced the international
competitiveness of many U.S. industries,
contributed
to unemployment
in the
trade-sensitive
sectors of the economy,
and heightened calls for protectionist
legislation. Although the dollar has
since depreciated in foreign-exchange
markets, many analysts contend that it
remains "overvalued"
or "too high."
Complaints about the performance of
the dollar in recent years have renewed
interest among policymakers
in managing exchange rates through more frequent exchange-market
intervention.
Some analysts advocate alternative exchange-rate systems which, in their
view, would limit the ability of exchange rates to deviate from their socalled equilibrium values.
There is considerable disagreement
and misunderstanding
about what the
term "overvalued"
means. It implies
that the present value of the dollar is
incorrect in some sense, that it is unsustainable, and that the observer knows
the correct, or equilibrium,
rate. In this
Economic Commentary, we discuss various interpretations
of "equilibrium"
and of "overvalued"
exchange rates.

Equilibrium and the
Foreign Exchange Market
An exchange rate is the price of one
nation's currency in terms of another's.
Like all prices, exchange rates are
determined by the laws of supply and

Material may be reprinted
provided that the
source is credited. Please send copies of reprinted
materials
to the editor.

january 1, 1986

Federal Reserve Bank of Cleveland

Owen F. Humpage is an economist with the Federal Reserve Bank of Cleveland. Nicholas V.
Karamouzis is an assistant professor in the
Department of Economics at Case Western Reserve
University in Cleveland, Ohio.
The views stated herein are those of the authors
and not necessarily those of the Federal Reserve
Bank of Clevela nd or of the Board of Governors of
the Federal Reserve System.

demand. A currency appreciates in the
foreign-exchange
market when the
quantity demanded exceeds the quantity supplied. Individuals acquire foreign currency primarily because they
wish to obtain something else with it.
They might wish to purchase foreign
goods and services, or to invest in foreign plants and equipment, or to hold a
foreign financial asset. Consequently,
the factors that underlie the demand
for these items underlie the demand for
foreign currency. I
There are many such factors, but differences in prices, income levels, and
interest rates among nations seem to
determine exchange rates most directly.
Prices, income levels, and interest
rates, in turn, are influenced by monetary and fiscal policies, by technological
developments,
and by other variables.
Often the connections between these
economic variables and exchange rates
are complex and the relative importance of individual factors can change."
It is also important to remember that
exchange markets are forward looking;
participants
adjust their exchange-rate
quotes when expectations
of future
economic and political events change.
Economists define an equilibrium
price as that which, at a given time,
balances quantities demanded with
quantities supplied in an unrestricted
market. In this sense, the dollar is seldom overvalued. Exchange-market
traders around the world continually
assess market information and take

actions that move exchange rates minute by minute to quickly offset emerging or perceived imbalances in supply
and demand.
Of course, exchange-market
analysts
have a more stable view of equilibrium
in mind when they label an exchange
rate overvalued. Because of the great difficulty in specifying all the factors underlying the long-term equilibrium,
exchange-market
analysts usually base
their assessment
of what constitutes
an equilibrium exchange rate on a
limited set of factors that they regard
as the "fundamental"
determinants
of
exchange rates. This set usually includes the current account and relative
rates of inflation." If exchange-market
developments push exchange rates away
from the levels dictated by these socalled fundamentals,
then the exchange
rates are considered overvalued or
undervalued,
as the case may be, even
though they are equating quantities of
currencies demanded and supplied.
While exchange-market
analysts
might define exchange-rate
equilibrium
in terms of the trade account, or in
terms of relative inflation rates, they do
not expect the rate to move continually
along such an equilibrium path. Economists have observed that prices and
trade-account
transactions
adjust
slowly to economic shocks and policy
changes, while exchange rates adjust
quickly. Consequently,
following an
unexpected event, or a change in the
market's expectations,
exchange rates
can overshoot these equilibrium paths.
Often, therefore, overvalued exchange
rates are consistent with the efficient
operation of the exchange market. In

1. Because one purchases
a foreign currency
with dollars, the demand for a foreign currency
creates a supply of dollars.

3. The current account measures trade in goods
and services and unilateral
transfers.
Some analysts focus only on trade flows.

2. See Owen F. Humpage and Nicholas V. Karamouzis, "The Dollar in the Eighties,"
Economic
Commentary, Federal Reserve Bank of Cleveland,
September
1, 1985.