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or reflect, a lack of confidence in U.S.
economic policies. The U.S. dollar is a
key currency in world markets. Much
of the world's trade, even trade not
directly involving the United States, is
conducted in dollars, and foreigners
have accumulated large holdings of dollar assets in recent years. The confidence problem associated with a rapid
dollar depreciation would be of less
concern to the United States and the
world if the dollar was not such an
important currency.
A lack of confidence in the dollar, as
occurred in 1977 and 1978, would manifest itself as a reluctance of foreigners
to hold dollars. Trading in dollars
would become "one way," with the dollar depreciating very rapidly. The
result would be intense pressure on
U.S. interest rates and on U.S. prices.
The decline in the dollar could be accentuated, because when traders cannot
accurately judge the correct value of
the dollar they tend to project recent
movements into the future, thereby
exaggerating the recent movements.
It is difficult to tell when a "lack of
confidence" in the dollar and U.S. economic policies might occur. Despite the
rapidity of the recent dollar depreciation, there does not seem to be the degree
of disorder in the market that characterized the dollar's depreciation in the late
1970s. Moreover, the dollar continues
to remain above levels many economists
believe are consistent with a long-term
balance in the trade-accounts. Since the
United States recently became a net
debtor, the market might accept a
somewhat lower dollar to help finance
and retire this debt.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

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

On the other hand, we do not fully
understand the psychology of confidence. In an attempt to avoid the consequences of a loss of confidence in the
dollar, it is in the interest of this country to seek a gradual depreciation. Federal Reserve Chairman Vo1cker's recent
expressions of concern about the pace
of depreciation perhaps could be viewed
as an attempt to bolster the market's
confidence in the dollar and in U.S.
economic policy.
The Uncertain Future
At present, concerns about inflation
accelerating in the near future are not
widely shared. In the view of many
analysts, the inflation problem has
passed. Recent sharp declines in oil prices suggest that further general price
improvements are on the horizon. Conventional measures of capacity and
employment suggest that cost pressures are not imminent.
In some ways, however, the current
situation parallels 1977, when many
analysts and policymakers thought
that inflation was declining, that
capacity was ample, and that the dollar
was too high. The United States geared
policy to stimulating real economic
activity and encouraged a dollar depreciation. The situation, however, deteriorated quickly, and confidence in the
dollar waned as inflation in the United
States accelerated sharply in late 1978
and in 1979.

How quickly could the current situation turn around? Could 1987 or 1988
bring a surprising rise either in the rate
of inflation or in U.S. interest rates?
Productivity and labor-force growth in
the United States remains very low,
casting doubt on the traditional relationships between inflation and excess
capacity. Furthermore, the money
stock grew quite rapidly until recently.
Historically, rapid money growth and
higher rates of inflation are associated.
Although the Gramm-Rudman legislation is encouraging, it has not yet delivered very much in deficit reductions.
Moreover, the recent declines in oil prices will have major impacts on income
and, as explained earlier, could alter
international competitive positions.
Conclusion
Despite the rapidity of the dollar's
recent depreciation, it apparently has
not yet had a detrimental effect either
on economic growth or on inflation.
Exchange markets have not lost confidence in the dollar, but the situation
bears close watching, because experience has shown that the economic climate can change quickly. In view of the
uncertainties about the future, economic policies that promote a gradual,
rather than a rapid depreciation appear
preferable. Such policies would provide
time to watch future developments
unfold and give policymakers time to
encourage further depreciation if, and
when, conditions warrant.

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

Address Correction Requested: Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

Federal Reserve Bank of Cleveland

March 15, 1986
ISSN 0428·1276

ECONOMIC
COMMENTARY
Over the past 12 months, the dollar has
depreciated approximately 30 percent
on a trade-weighted average basis
against the currencies of our major
trading partners.' This recent depreciation, at a rate of approximately 2.4 percent per month, has been the most
rapid since the floating-exchange-rate
system began in March 1973. In contrast, between September 1977 and
October 1978, a period characterized by
a worldwide lack of confidence in U.S.
economic policies, the dollar depreciated at a pace of only 1.3 percent per
month on a trade-weighted basis.
Recently Federal Reserve Chairman
Paul Vo1cker expressed concern about
the speed with which the dollar is
depreciating. Others, however, dismiss
such concerns, noting that the large
U.S. trade deficit fully justifies the dollar's depreciation, and that the speed of
the recent depreciation is not unlike
that of the dollar's recent appreciation
(see chart 1).
This Economic Commentary suggests
why U.S. policymakers might be concerned about the rapidity of the recent
dollar depreciation. Concerns could
stem from: 1) the varying speeds at
which different economic variables can
adjust to a depreciation, 2) the interrelationship between confidence in the
dollar and the rapidity of a dollar
depreciation, and 3) the depreciation's
contribution to our uncertainties about
the economic outlook.

Owen F. Humpage is an economist at the Federal
Reserve Bank of Cleveland. The author would like
to thank Nicholas V Karamouzis for his helpful
comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Should We Be
Concerned About
the Speed of the
Depreciation?
by Owen F. Humpage

Chart 1 U.S. Dollar Trade Weighted Exchange Rate
1601rPercent

~----~

~~7~O~~~~~~~~~~~~~~~~~~~~~~~~~~
SOURCE: Board of Governors of the Federal Reserve System.

Recent Trends in the Dollar
To understand the effects of depreciation on the economy, one must first understand the forces that prompted the
dollar's depreciation. Dollar movements
generally are not independent events;
other economic developments cause
movements in the exchange value of
the dollar. Often these initial economic
influences will influence the way in
which the effects of a depreciation feed
back again throughout the economy.
An exchange rate is the price of one
nation's currency in terms of another's.

1. The trade-toeighted dollar is a weighted average
of dollar exchange rates against the currencies of
Germany, Japan, France, the United Kingdom,
Canada, italy, the Netherlands, Belgium,
Sweden, and Switzerland. The weights are
shares of each country's total trade in the trade
of all 10 countries from 1972 through 1976.

Like all prices, exchange rates are
determined by the law of supply and
demand. Since February 1985, the
demand for dollars appears to have
declined. An important factor against
holding dollar-denominated assets has
been the narrowing in many international interest-rate differentials, and
the widely held perception that U.S.
interest rates will continue to decline in
the future. Most economic forecasts

currently support this interest-rate outlook on the belief that U.S. monetary
policy is not likely to tighten, that U.S.
economic activity will not accelerate
sharply, and that Gramm-Rudman legislation will result in substantial reductions in the federal deficit.
Recent oil-price trends also may have
reduced demand for dollars in exchange
markets. With worldwide oil prices and
payments denominated in dollars, a
decline in the price of crude oil will
tend to reduce the demand for dollars,
at least in the near term." The oil price
decline also could promote a depreciation by altering the relative price performance and competitive advantages
of the United States and its trading
partners. Many U.S. trading partners
are more dependent on imported oil
than the United States is.
While interest-rate trends and oil
prices have reduced the demand for dollars, the growing trade deficit has continued to supply dollars to foreignexchange markets. The current-account,
which measures U.S. trade in goods and
services and certain unilateral transfers of funds, posted a record $117.7 billion deficit in 1985, $10 billion higher
than the deficit in the previous year.
The Effects of a Dollar
Depreciation
Dollar depreciations have many effects
on the economy, both favorable and unfavorable. For purposes of discussion, we
consider only trade, price-level, and
interest-rate effects. The impact of exchange-rate depreciation, whether it improves or worsens the economic outlook,
depends largely on the relative strength
of these three effects. They, in turn, depend on many factors, one of which is
the speed at which the dollar depreciates.
When the dollar depreciates in foreign exchange markets, it becomes less
expensive in terms of foreign currencies. A depreciation, therefore, tends to
lower the foreign-currency prices of our
exports and tends to raise the dollar
price of our imports. This relative price
change shifts worldwide demand
toward U.S. goods and services, and
stimulates production and employment
in U.S. industries that export or that
directly compete with imports.

2. This assumes that the quantity of imported oil
does not rise so much in response to the price decline as to increase the total expenditure for oil.

Adjustments in trade patterns following an exchange-rate change are not
instantaneous. Studies suggest that
trade patterns take from six to 12
months before they begin to respond to
changes in exchange rates. It simply
takes time for firms to find new suppliers for the now higher-priced imports,
especially if they are produced to the
specifications of the importers. Similarly, it takes time for domestic producers to find markets for their products abroad. Foreign trade is often
conducted under longer-term contracts
that cannot be abrogated or renegotiated because of small changes in
exchange rates.
The extent to which a depreciation of
the dollar will shift demand to U.S.
producers also depends on the extent to
which foreigners absorb part of the relative price changes through cuts in
their profit margins. A recent study by
the Federal Reserve Bank of New York
suggested that as the dollar strengthened in the past few years, foreign
exporters greatly increased their profit
margins.' Given the sluggish pace of
economic recovery abroad and the importance of the U.S market, foreigners
are likely to defend their market shares
aggressively by cutting profit margins
as the dollar depreciates.
The recent behavior of the U.S. trade
balance illustrates the sluggishness
with which it responds to changes in
the exchange value of the dollar. Despite the sharp dollar depreciation, the
U.S. trade deficit widened last year;
exports fell and imports continued to
expand. Many economists expect only a
fairly modest improvement in the U.S.
trade balance until late in 1986.
A second effect of a dollar depreciation results from its impact on prices.
Depreciation tends to raise the overall
level of prices in the United States. The
impact on prices will be greater: (1) if
the depreciation is large and not likely
to be reversed soon; (2) if the foreign
producers do not try to offset the
depreciation by cutting their prices; (3)
if domestic producers are operating
close to capacity, or (4) if the Federal
Reserve System is conducting an
expansionary monetary policy.

3. See Charles Pigott and Vincent Reinhart, "The
Strong Dollar and U.S. Inflation," Federal
Reserve Bank of New York Quarterly Review,
Autumn 1985, pp. 23-29.

The most immediate price impact of
a depreciation results as the exchangerate change raises the cost of imported
goods. The costs to firms that use
imports in their production processes
increase. As worldwide demand shifts
to U.S. exports and to U.S. industries
that compete with imports, prices in
these industries also begin to rise.
Initially, the price effects will be modest, but they will strengthen as production in trade-related industries reaches
full capacity.
If monetary policy is accommodative,
the price pressures from the depreciation eventually will ripple back to the
very basic factors of production. Based
on the relationship between exchangerate depreciations and changes in the
consumer-price index during the 1970s,
one could expect recent exchange-rate
patterns by themselves to add about
one percentage point to the inflation
rate this year and approximately l.5
percentage points to the inflation rate
in 1987. However, as foreigners cut
profit margins to defend their market
share, they will blunt most of the price
effects of the recent dollar depreciation.
In addition, the recent declines in oil
prices will mask the remaining price
effects of the depreciation over the next
six to eight quarters.
Under certain circumstances, depreciation could result in higher U.S.
interest rates. In recent years, credit
demands in the United States exceeded
domestic savings. A substantial inflow
of foreign savings to the United States,
which accompanied our trade deficit
and contributed to the past strength of
the dollar, helped finance our credit
demands at interest rates below those
that otherwise would have prevailed.
This inflow of foreign savings totaled
approximately $238 billion over the last
four years (see chart 2). As the current
dollar depreciation reduces the trade
deficit and, consequently, the inflow of
foreign savings, the United States
could experience higher domestic interest rates. This would be especially true
if foreigners expected the depreciation
to continue. The depreciation might
also contribute to pressure on interest
rates as it raised domestic prices and
inceased economic activity in the traderelated sectors of the economy. U.S.
interest rates would rise as the dollar

depreciated in order to reduce the
domestic demand for credit and to
encourage domestic savings.
At present, this does not appear to be
happening. A general decline in U.S.
interest rates has accompanied the dollar's depreciation. Recent Federal
Reserve policies have encouraged lower
domestic interest rates, and the market
does not expect monetary policy to
tighten significantly in the near future.
The Gramm-Rudman legislation prom-·
ises future reductions in federal credit
demands, and economic activity is not
so robust as to suggest heavy private
credit demands in the near term.
The net effect of an exchange-rate
depreciation on real GNP depends on
the balance between the positive trade
effects and the negative interest-rate
effects. Various economic models project conflicting results.' What will
actually happen depends, to a large
extent on what else in going on as the
dollar depreciates, but the speed of the
depreciation seems to be important.

Chart 2 Foreign Savings Flow and Total U.S. Savings
Billions of dollars, sa at annual rates

150r- of dollars, sa at annual rates
Billions

The Speed of Adjustment Problem
Because such economic variables as
prices, trade flows and interest rates
adjust to exchange-rate changes at different rates, the speed at which the dollar depreciates is of concern. Exchange
rates, interest rates, and trade flows
work together to maintain a balance
between the supply of dollars and the
demand for dollars. One can think of
the current-account deficit as largely
determining the supply of dollars being
pumped onto the foreign exchange
market, and one can envision the
demand for dollars as being determined
by foreigner's desires buy U.S. goods
and services or to invest in dollardenominated assets.
As illustrated above, a decrease in
the demand for dollars, or an increase
in the supply of dollars, will cause a
depreciation of the dollar that will
work to reestablish an equilibrium in
the exchange market. This will be done
by reducing the current-account deficit,
thereby reducing the quantity of dollars supplied to exchange markets,
and/or by increasing interest rates,
thereby increasing the quantity of dollars demanded in the market.

Whereas a gradual shift out of dollars produces a gradual depreciation
and allows time for positive trade
effects to offset negative interest-rate
effects, a rapid shift out of dollars
would produce a rapid depreciation and
could force most of the initial economic
adjustment to take place through
higher interest rates. This would occur
because trade flows and the current account adjust slowly to exchange-rate
changes. U.S. interest rates would need
to rise sufficiently above foreign interest rates to compensate foreign investors for the expected depreciation of the
dollar. In addition, the dollar would be
likely to overshoot its new equilibrium
when the shift out of dollars is rapid because, with current account flows slow
to adjust, exchange rates are likely to
depreciate further to balance quantities
of dollars supplied and demanded."

4. See Arnold Kling, "Simulating Exchange Rate
Shocks in the MPS and MCM Models: An Evaluation," International Finance Discussion Papers
No. 260, August 1985.

5. In most markets, demand shifts result in
bigger price changes in the short run than in the
long run, because quantities supplied to the
market do not change much in the short run.

~

NOTE: Quarterly data are at seasonally adjusted annual rates.
SOURCE: Board of Governors of the Federal Reserve System; Flow-of-funds accounts.

The speed of adjustment could create
special problems for the Federal
Reserve System, especially if the System is attempting to reduce interest
rates. A rapid depreciation could put
additional pressure on interest rates,
which could cause the Federal Reserve
to expand the money supply. This
could create a process in which monetary expansion induces a further rapid
dollar depreciation which, in turn,
results in higher interest rates and faster money growth. The net effect eventually could be a substantial acceleration in the inflation rate in the United
States, along with a heightening of
inflation expectation.
The Confidence Problem
A second concern of the Federal
Reserve System is that rapid depreciation of the dollar could either produce,

currently support this interest-rate outlook on the belief that U.S. monetary
policy is not likely to tighten, that U.S.
economic activity will not accelerate
sharply, and that Gramm-Rudman legislation will result in substantial reductions in the federal deficit.
Recent oil-price trends also may have
reduced demand for dollars in exchange
markets. With worldwide oil prices and
payments denominated in dollars, a
decline in the price of crude oil will
tend to reduce the demand for dollars,
at least in the near term." The oil price
decline also could promote a depreciation by altering the relative price performance and competitive advantages
of the United States and its trading
partners. Many U.S. trading partners
are more dependent on imported oil
than the United States is.
While interest-rate trends and oil
prices have reduced the demand for dollars, the growing trade deficit has continued to supply dollars to foreignexchange markets. The current-account,
which measures U.S. trade in goods and
services and certain unilateral transfers of funds, posted a record $117.7 billion deficit in 1985, $10 billion higher
than the deficit in the previous year.
The Effects of a Dollar
Depreciation
Dollar depreciations have many effects
on the economy, both favorable and unfavorable. For purposes of discussion, we
consider only trade, price-level, and
interest-rate effects. The impact of exchange-rate depreciation, whether it improves or worsens the economic outlook,
depends largely on the relative strength
of these three effects. They, in turn, depend on many factors, one of which is
the speed at which the dollar depreciates.
When the dollar depreciates in foreign exchange markets, it becomes less
expensive in terms of foreign currencies. A depreciation, therefore, tends to
lower the foreign-currency prices of our
exports and tends to raise the dollar
price of our imports. This relative price
change shifts worldwide demand
toward U.S. goods and services, and
stimulates production and employment
in U.S. industries that export or that
directly compete with imports.

2. This assumes that the quantity of imported oil
does not rise so much in response to the price decline as to increase the total expenditure for oil.

Adjustments in trade patterns following an exchange-rate change are not
instantaneous. Studies suggest that
trade patterns take from six to 12
months before they begin to respond to
changes in exchange rates. It simply
takes time for firms to find new suppliers for the now higher-priced imports,
especially if they are produced to the
specifications of the importers. Similarly, it takes time for domestic producers to find markets for their products abroad. Foreign trade is often
conducted under longer-term contracts
that cannot be abrogated or renegotiated because of small changes in
exchange rates.
The extent to which a depreciation of
the dollar will shift demand to U.S.
producers also depends on the extent to
which foreigners absorb part of the relative price changes through cuts in
their profit margins. A recent study by
the Federal Reserve Bank of New York
suggested that as the dollar strengthened in the past few years, foreign
exporters greatly increased their profit
margins.' Given the sluggish pace of
economic recovery abroad and the importance of the U.S market, foreigners
are likely to defend their market shares
aggressively by cutting profit margins
as the dollar depreciates.
The recent behavior of the U.S. trade
balance illustrates the sluggishness
with which it responds to changes in
the exchange value of the dollar. Despite the sharp dollar depreciation, the
U.S. trade deficit widened last year;
exports fell and imports continued to
expand. Many economists expect only a
fairly modest improvement in the U.S.
trade balance until late in 1986.
A second effect of a dollar depreciation results from its impact on prices.
Depreciation tends to raise the overall
level of prices in the United States. The
impact on prices will be greater: (1) if
the depreciation is large and not likely
to be reversed soon; (2) if the foreign
producers do not try to offset the
depreciation by cutting their prices; (3)
if domestic producers are operating
close to capacity, or (4) if the Federal
Reserve System is conducting an
expansionary monetary policy.

3. See Charles Pigott and Vincent Reinhart, "The
Strong Dollar and U.S. Inflation," Federal
Reserve Bank of New York Quarterly Review,
Autumn 1985, pp. 23-29.

The most immediate price impact of
a depreciation results as the exchangerate change raises the cost of imported
goods. The costs to firms that use
imports in their production processes
increase. As worldwide demand shifts
to U.S. exports and to U.S. industries
that compete with imports, prices in
these industries also begin to rise.
Initially, the price effects will be modest, but they will strengthen as production in trade-related industries reaches
full capacity.
If monetary policy is accommodative,
the price pressures from the depreciation eventually will ripple back to the
very basic factors of production. Based
on the relationship between exchangerate depreciations and changes in the
consumer-price index during the 1970s,
one could expect recent exchange-rate
patterns by themselves to add about
one percentage point to the inflation
rate this year and approximately l.5
percentage points to the inflation rate
in 1987. However, as foreigners cut
profit margins to defend their market
share, they will blunt most of the price
effects of the recent dollar depreciation.
In addition, the recent declines in oil
prices will mask the remaining price
effects of the depreciation over the next
six to eight quarters.
Under certain circumstances, depreciation could result in higher U.S.
interest rates. In recent years, credit
demands in the United States exceeded
domestic savings. A substantial inflow
of foreign savings to the United States,
which accompanied our trade deficit
and contributed to the past strength of
the dollar, helped finance our credit
demands at interest rates below those
that otherwise would have prevailed.
This inflow of foreign savings totaled
approximately $238 billion over the last
four years (see chart 2). As the current
dollar depreciation reduces the trade
deficit and, consequently, the inflow of
foreign savings, the United States
could experience higher domestic interest rates. This would be especially true
if foreigners expected the depreciation
to continue. The depreciation might
also contribute to pressure on interest
rates as it raised domestic prices and
inceased economic activity in the traderelated sectors of the economy. U.S.
interest rates would rise as the dollar

depreciated in order to reduce the
domestic demand for credit and to
encourage domestic savings.
At present, this does not appear to be
happening. A general decline in U.S.
interest rates has accompanied the dollar's depreciation. Recent Federal
Reserve policies have encouraged lower
domestic interest rates, and the market
does not expect monetary policy to
tighten significantly in the near future.
The Gramm-Rudman legislation prom-·
ises future reductions in federal credit
demands, and economic activity is not
so robust as to suggest heavy private
credit demands in the near term.
The net effect of an exchange-rate
depreciation on real GNP depends on
the balance between the positive trade
effects and the negative interest-rate
effects. Various economic models project conflicting results.' What will
actually happen depends, to a large
extent on what else in going on as the
dollar depreciates, but the speed of the
depreciation seems to be important.

Chart 2 Foreign Savings Flow and Total U.S. Savings
Billions of dollars, sa at annual rates

150r- of dollars, sa at annual rates
Billions

The Speed of Adjustment Problem
Because such economic variables as
prices, trade flows and interest rates
adjust to exchange-rate changes at different rates, the speed at which the dollar depreciates is of concern. Exchange
rates, interest rates, and trade flows
work together to maintain a balance
between the supply of dollars and the
demand for dollars. One can think of
the current-account deficit as largely
determining the supply of dollars being
pumped onto the foreign exchange
market, and one can envision the
demand for dollars as being determined
by foreigner's desires buy U.S. goods
and services or to invest in dollardenominated assets.
As illustrated above, a decrease in
the demand for dollars, or an increase
in the supply of dollars, will cause a
depreciation of the dollar that will
work to reestablish an equilibrium in
the exchange market. This will be done
by reducing the current-account deficit,
thereby reducing the quantity of dollars supplied to exchange markets,
and/or by increasing interest rates,
thereby increasing the quantity of dollars demanded in the market.

Whereas a gradual shift out of dollars produces a gradual depreciation
and allows time for positive trade
effects to offset negative interest-rate
effects, a rapid shift out of dollars
would produce a rapid depreciation and
could force most of the initial economic
adjustment to take place through
higher interest rates. This would occur
because trade flows and the current account adjust slowly to exchange-rate
changes. U.S. interest rates would need
to rise sufficiently above foreign interest rates to compensate foreign investors for the expected depreciation of the
dollar. In addition, the dollar would be
likely to overshoot its new equilibrium
when the shift out of dollars is rapid because, with current account flows slow
to adjust, exchange rates are likely to
depreciate further to balance quantities
of dollars supplied and demanded."

4. See Arnold Kling, "Simulating Exchange Rate
Shocks in the MPS and MCM Models: An Evaluation," International Finance Discussion Papers
No. 260, August 1985.

5. In most markets, demand shifts result in
bigger price changes in the short run than in the
long run, because quantities supplied to the
market do not change much in the short run.

~

NOTE: Quarterly data are at seasonally adjusted annual rates.
SOURCE: Board of Governors of the Federal Reserve System; Flow-of-funds accounts.

The speed of adjustment could create
special problems for the Federal
Reserve System, especially if the System is attempting to reduce interest
rates. A rapid depreciation could put
additional pressure on interest rates,
which could cause the Federal Reserve
to expand the money supply. This
could create a process in which monetary expansion induces a further rapid
dollar depreciation which, in turn,
results in higher interest rates and faster money growth. The net effect eventually could be a substantial acceleration in the inflation rate in the United
States, along with a heightening of
inflation expectation.
The Confidence Problem
A second concern of the Federal
Reserve System is that rapid depreciation of the dollar could either produce,

or reflect, a lack of confidence in U.S.
economic policies. The U.S. dollar is a
key currency in world markets. Much
of the world's trade, even trade not
directly involving the United States, is
conducted in dollars, and foreigners
have accumulated large holdings of dollar assets in recent years. The confidence problem associated with a rapid
dollar depreciation would be of less
concern to the United States and the
world if the dollar was not such an
important currency.
A lack of confidence in the dollar, as
occurred in 1977 and 1978, would manifest itself as a reluctance of foreigners
to hold dollars. Trading in dollars
would become "one way," with the dollar depreciating very rapidly. The
result would be intense pressure on
U.S. interest rates and on U.S. prices.
The decline in the dollar could be accentuated, because when traders cannot
accurately judge the correct value of
the dollar they tend to project recent
movements into the future, thereby
exaggerating the recent movements.
It is difficult to tell when a "lack of
confidence" in the dollar and U.S. economic policies might occur. Despite the
rapidity of the recent dollar depreciation, there does not seem to be the degree
of disorder in the market that characterized the dollar's depreciation in the late
1970s. Moreover, the dollar continues
to remain above levels many economists
believe are consistent with a long-term
balance in the trade-accounts. Since the
United States recently became a net
debtor, the market might accept a
somewhat lower dollar to help finance
and retire this debt.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

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

On the other hand, we do not fully
understand the psychology of confidence. In an attempt to avoid the consequences of a loss of confidence in the
dollar, it is in the interest of this country to seek a gradual depreciation. Federal Reserve Chairman Vo1cker's recent
expressions of concern about the pace
of depreciation perhaps could be viewed
as an attempt to bolster the market's
confidence in the dollar and in U.S.
economic policy.
The Uncertain Future
At present, concerns about inflation
accelerating in the near future are not
widely shared. In the view of many
analysts, the inflation problem has
passed. Recent sharp declines in oil prices suggest that further general price
improvements are on the horizon. Conventional measures of capacity and
employment suggest that cost pressures are not imminent.
In some ways, however, the current
situation parallels 1977, when many
analysts and policymakers thought
that inflation was declining, that
capacity was ample, and that the dollar
was too high. The United States geared
policy to stimulating real economic
activity and encouraged a dollar depreciation. The situation, however, deteriorated quickly, and confidence in the
dollar waned as inflation in the United
States accelerated sharply in late 1978
and in 1979.

How quickly could the current situation turn around? Could 1987 or 1988
bring a surprising rise either in the rate
of inflation or in U.S. interest rates?
Productivity and labor-force growth in
the United States remains very low,
casting doubt on the traditional relationships between inflation and excess
capacity. Furthermore, the money
stock grew quite rapidly until recently.
Historically, rapid money growth and
higher rates of inflation are associated.
Although the Gramm-Rudman legislation is encouraging, it has not yet delivered very much in deficit reductions.
Moreover, the recent declines in oil prices will have major impacts on income
and, as explained earlier, could alter
international competitive positions.
Conclusion
Despite the rapidity of the dollar's
recent depreciation, it apparently has
not yet had a detrimental effect either
on economic growth or on inflation.
Exchange markets have not lost confidence in the dollar, but the situation
bears close watching, because experience has shown that the economic climate can change quickly. In view of the
uncertainties about the future, economic policies that promote a gradual,
rather than a rapid depreciation appear
preferable. Such policies would provide
time to watch future developments
unfold and give policymakers time to
encourage further depreciation if, and
when, conditions warrant.

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Federal Reserve Bank of Cleveland

March 15, 1986
ISSN 0428·1276

ECONOMIC
COMMENTARY
Over the past 12 months, the dollar has
depreciated approximately 30 percent
on a trade-weighted average basis
against the currencies of our major
trading partners.' This recent depreciation, at a rate of approximately 2.4 percent per month, has been the most
rapid since the floating-exchange-rate
system began in March 1973. In contrast, between September 1977 and
October 1978, a period characterized by
a worldwide lack of confidence in U.S.
economic policies, the dollar depreciated at a pace of only 1.3 percent per
month on a trade-weighted basis.
Recently Federal Reserve Chairman
Paul Vo1cker expressed concern about
the speed with which the dollar is
depreciating. Others, however, dismiss
such concerns, noting that the large
U.S. trade deficit fully justifies the dollar's depreciation, and that the speed of
the recent depreciation is not unlike
that of the dollar's recent appreciation
(see chart 1).
This Economic Commentary suggests
why U.S. policymakers might be concerned about the rapidity of the recent
dollar depreciation. Concerns could
stem from: 1) the varying speeds at
which different economic variables can
adjust to a depreciation, 2) the interrelationship between confidence in the
dollar and the rapidity of a dollar
depreciation, and 3) the depreciation's
contribution to our uncertainties about
the economic outlook.

Owen F. Humpage is an economist at the Federal
Reserve Bank of Cleveland. The author would like
to thank Nicholas V Karamouzis for his helpful
comments.
The views stated herein are those of the author
and not necessarily those of the Federal Reserve
Bank of Cleveland or of the Board of Governors of
the Federal Reserve System.

Should We Be
Concerned About
the Speed of the
Depreciation?
by Owen F. Humpage

Chart 1 U.S. Dollar Trade Weighted Exchange Rate
1601rPercent

~----~

~~7~O~~~~~~~~~~~~~~~~~~~~~~~~~~
SOURCE: Board of Governors of the Federal Reserve System.

Recent Trends in the Dollar
To understand the effects of depreciation on the economy, one must first understand the forces that prompted the
dollar's depreciation. Dollar movements
generally are not independent events;
other economic developments cause
movements in the exchange value of
the dollar. Often these initial economic
influences will influence the way in
which the effects of a depreciation feed
back again throughout the economy.
An exchange rate is the price of one
nation's currency in terms of another's.

1. The trade-toeighted dollar is a weighted average
of dollar exchange rates against the currencies of
Germany, Japan, France, the United Kingdom,
Canada, italy, the Netherlands, Belgium,
Sweden, and Switzerland. The weights are
shares of each country's total trade in the trade
of all 10 countries from 1972 through 1976.

Like all prices, exchange rates are
determined by the law of supply and
demand. Since February 1985, the
demand for dollars appears to have
declined. An important factor against
holding dollar-denominated assets has
been the narrowing in many international interest-rate differentials, and
the widely held perception that U.S.
interest rates will continue to decline in
the future. Most economic forecasts