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$572 billion to $441 billion ($572 billion + 1.296), a reduction of $131 billion. This is a loss for the United States. Third, U.S. residents also held $313 billion equivalent of assets abroad denominated in foreign currencies. If foreign currency prices of U.S. imports fall by 20 percent of the dollar's depreciation, as discussed above, those import prices will fall by 7.4 percent. That price decline boosts the real value of those assets from $313 billion to $313 billion divided by (1-.074), an increase of $25 billion. This is a gain for the United States. In total, we can estimate that the dollar's 37 percent devaluation has decreased the real value of U.S. international assets $106 billion ($25 billion - $131 billion), and decreased the real value of U.S. internationalliabilities by $139 billion, for a net real gain to the United States of $33 billion. The calculationsabove are based on the effect of dollar depreciation since first quarter 1985 on asset positions at the end of 1984. The fourth step in the estimate takes account of the fact that there have been large additions to U.S. assets abroad and foreign assets in the United States since the end of 1984 that represent additional potential claims on U.S. and foreign goods (see table 1). The gains and losses on these additional assets here and abroad, caused by dollar depreciation, must be calculated separately in order to consider only the portion of the depreciation that occurred after the assets were accrued. The values of the assets here and abroad 9. Investors who expect dollar depreciation will, if possible, demand higher nominal returns on their international assets to compensate them for expected losses from depreciation; investors who 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. that accrued in 1985 are considered here to be changed only by dollar depreciation that occurred after fourth quarter 1985, and assets here and abroad that accrued in 1986 are considered here to be affected only by dollar depreciation that occurred after fourth quarter 1986. Calculations similar to those above indicate that the depreciation has given the United States a net gain of $18 billion on the accruals to assets that occurred in 1985. On accruals in 1986, the U.S. net gain was $7 billion. Taken together, the $33 billion gain, the $18 billion gain, and the $7 billion gain add to a total one-time gain for the United States of $58 billion." An alternative calculation of the changed potential claims on U.S. and foreign exports, made using actual changes in export and import prices, indicates a net one-time gain for the United States of $32 billion. Conclusions The dollar's 37 percent depreciation between the first quarter of 1985 and the third quarter of 1987 worsened our terms of trade, causing a continuing annual real loss to the nation estimated to be between $24 billion and $100 billion. This annual loss will grow as the volume of trade grows. The ann ual loss will be partially offset by the one-time gain from the dollar depreciation's effect on the potential purchasing power of U.S. expect to gain from depreciation will accept lower nominal returns, if necessary. Such adjustments in nominal returns will mitigate the gains and losses and reduce the net gain to the United States from changes in the value of U.S. interna- international assets and liabilities, which we have estimated to be between $32 billion and $58 billion. Comparing the midpoint of the range of annual loss estimates, $62 billion, to the midpoint of the one-time gain estimates of about $45 billion, we can see that the onetime gain will be offset by the annual losses in less than a year, after which the losses will continue to accrue, year after year. Although a reduction in the terms of trade is costly, that cost may be unavoidable if the United States is to reduce its trade deficit. A reduction of the trade deficit is generally considered desirable because it will reduce the need for the United States to import capital and thus to increase its net international indebtedness, and also because reduction of the trade deficit is generally believed to stimulate domestic production and employment. Of course, faster growth of the economies of our major trading partners would tend to reduce the U.S. trade deficit without a worsening of the terms of trade. However, foreign governments may be reluctant to stimulate their economies if they expect such action to be inflationary and, in any event, faster foreign growth is unlikely to fully eliminate the trade deficit. Slower growth of the U.S. economy also would tend to reduce the U.S. trade deficit, but that is, of course, an undesirable method of improving the trade balance. tional assets and liabilities. However, most asset holders are locked into nominal returns that they cannot alter when depreciation occurs, so the offset here will be only partial. 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 October 15, 1987 ISSN 0428·1276 iECONOMIC COMMENTARY The foreign-exchange value of the dollar has been depreciating for more than two-and-a-half years. Most discussion about this depreciation has focused on traditional issues, such as its effects on the overall trade balance, economic growth, import prices, inflation, and interest rates.' Some other important effects, however, have generally been overlooked. Dollar depreciation, for example, is supposed to improve the U.S. trade balance partly by increasing the cost of foreign goods, thus reducing the volume of imports by making them less attractive to consumers. Higher import prices, however, will have a significant real cost to the nation. The resources the United States would have to expend to purchase a given volume of imports would increase. Only if the prices of U.S. export goods also increased, so that there were greater export earnings from a given volume of exports to help pay the higher import bill, would some of this higher cost be offset. There has been practically no public discussion of the import cost increase, nor attempts to measure it, despite the fact that the net cost to the United States is potentially large. Failure to reduce the trade deficit is also costly, however, in the sense that it implies continued growth of U.S. net indebtedness to foreigners. This trend, in contrast, has received much public attention. Another potential implication resulting from dollar depreciation centers on the foreign assets owned by U.S. citizens, and on the debts that Americans owe to foreigners. Depending on the currencies in which they are denominated, the values of these assets and liabilities will either be increased or decreased by dollar depreciation. But again, there has been little public discussion of this effect of depreciation. This Economic Commentary discusses and estimates the costs and benefits that dollar depreciation imposes through changes in the prices of imports and exports, and the costs and benefits imposed through changes in the potential purchasing power of U.S. international assets and liabilities. Because of inadequacies in the data and uncertainty about which are the best concepts of the gains and losses, a range of estimates is presented. Despite their lack of precision, the estimates nevertheless indicate the signs and general magnitudes of these gains and losses, and help round out public discussion of the costs and benefits of dollar depreciation. It is not the purpose of this presentation, however, to argue that dollar depreciation is either good or bad. Such a judgement must be based on an evaluation of all of the effects of depreciation, not just on the net loss that is calculated here. Such an overall evaluation is beyond the scope of this essay. Gerald H. Anderson is an economic advisor at the Federal Reserve Bank of Cleveland. The author would like to thank John Scadding, Mark Sniderman, and EJ Stevens for 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. 1. For a discussion of these traditional issues, see Gerald H. Anderson, "Is Dollar Depreciation Desirable?," Economic Commentary, December IS, 1985. Change in Terms of Trade The terms of trade is a measure indicating the amount of imports that can be purchased with a unit of exports. It can be described as the ratio of the prices a nation receives for its exports to the prices it pays for its imports, with all prices measured in the same 2. The equation for calculating the responsiveness of the terms of trade to a change in exchange rates is given in H. Robert Heller, Inter- Two Neglected Implications of Dollar Depreciation by Gerald H. Anderson currency. A decrease in this ratio would be considered a deterioration in the nation's terms of trade: the nation would be worse off economically after the decrease because its exports would have less buying power. A terms-of-trade loss is not the same as a reduction in a nation's real gross national product (GNP). Real GNP might be unchanged, but a nation with a terms-of-trade loss would still be worse off because a given physical quantity of its goods can now be traded for only a smaller amount of foreign goods. Thus, even if the nation's production of goods and services did not change, the resources it would have available for consumption, investment, and government would be smaller because its exchanges of goods with other nations would be on lessfavorable terms. The amount by which dollar depreciation changes the prices of U.S. imports and exports depends on the size of the depreciation and on the extent to which U.S. and foreign exporters try to offset its effects. A foreign exporter, of Japanese cars, for example, could cushion some of the impact of a dollar decline on its sales by cutting the yen price of an automobile. As a result, the dollar price to U.S. importers will not rise by the full extent of the dollar's depreciation. In this case, there is less than full "pass-through" of the depreciation to import prices because the Japanese exporter has been willing to shave his profit margin. By the same token, U.S. exporters, finding themselves in a more competitive position because of the dollar's depreciation, may take advantage national Monetary Economics, 1974, Prentice Hall, Inc., Englewood Cliffs, N.J., page 101. Estimates of supply and demand elasticities of U.S. exports and imports are summarized in the Handbook of International Economics, Volume 2, North Holland Publishing Company, 1985, pages 1078, 1079, 1087, and 1088. of the situation to improve their profit margins by raising the dollar prices they charge. In such a case, there is also less than full pass-through of the dollar depreciation to the foreign-currency prices that foreigners pay for U.S. goods. The degree to which a depreciation is passed through as price changes, both in export and import markets, depends on how sensitive producers and consumers are to price changes - in other words, on the supply and demand elasticities for exports and imports. These elasticities will differ among products and will depend on many aspects of the market situation, including sellers' profit margins, the amount of idle capacity in the particular industry, expectations regarding the permanence of the exchange-rate change, the degree of competition, the terms of existing contracts between buyer and seller, and the strength of the buyers' demand for the product. Elasticities are usually larger in the long run than in the short run because buyers and sellers have more time to react. An estimate of the long-run terms-oftrade effect of dollar depreciation, calculated using econometric estimates of the supply and demand elasticities of U.S. imports and exports, indicates that for every 1 percent depreciation of the dollar, the U.S. terms of trade would deteriorate by 0.76 percent in the long run." This means that the physical amount of imports that the U.S. can purchase with the proceeds from a given physical amount of exports declines by about three-quarters of a percent for each 1 percent depreciation of the dollar. The dollar depreciated by a weighted average of about 37 percent against other major currencies between the first quarter of 1985 and the third quarter of 1987, and was continuing to fall in the fourth quarter. If the longrun relationship cited above holds, the 37 percent depreciation will eventually translate into a 28 percent worsening in the terms of trade. U.S. exports in 1985 and 1986 averaged $215 billion. Thus it appears that one cost of the dollar depreciation, imposed through a deterioration in the terms of trade, could eventually reach 28 percent of $215 billion, or about $60 billion per year. That is, because dollar deteriorate by 0.3 percent for each 1 depreciation leads to larger increases in percent depreciation of the dollar." In the dollar prices of imported goods than this case, the 37 percent depreciation in the dollar prices of exported goods, would cause an 11.1 percent drop in the the revenue from a given physical terms of trade (0.3 x 37%). The cost to quantity of goods exported after the the United States, measured in terms depreciation will, on average, purchase of the reduced real purchasing power of a smaller physical quantity of imports U.S_ exports, would be $24 billion per year (11.1% x $215 billion). The cost, than before the depreciation. The loss to the nation is the reduction in the measured in terms of the increased real physical quantity of imports earned by cost of imports, would be $40 billion per year (11.1% x $358 billion). exporting. This cost will continue year after year and will grow as the volume An alternative calculation yields simof exports grows. ilar results. That approach is to examine The loss calculation described above the actual change in terms of trade thus is conservative in that it ignores the far in the current episode of dollar defact that U.S. imports exceeded U.S. preciation. Since the dollar began its exports by an average of $143 billion in depreciation in early 1985, import 1985 and 1986. Imports that the U.S. is prices have risen much faster than exunable to finance with current export port prices. Between March 1985 and earnings are, in essence, purchased September 1987, prices of imports, with funds borrowed from foreigners." excluding fuels, rose about 18 percent while prices of exports rose only about If these loans are repaid, it is likely to be with the proceeds of future exports. 3 percent. Thus, the terms of trade Thus, imports are being purchased with have worsened by about 12.7 percent so current and future exports. The loss far." In the long run, of course, the from the worsening in the terms of terms of trade may worsen further or trade can be calculated to be the reverse some of their deterioration. If increase in the volume of exports they don't change, however, the annual needed, now or later, to pay for an cost to the nation would either be $27 unchanged volume of imports. U.S. billion (12.7% x $215 billion), or $45 billion (12.7% x $358 billion). imports in 1985 and 1986averaged $358 billion, so the loss is 28 percent of $358 The importance to the United States billion or about $100 billion per year. of these annual losses can be more easAlthough the volume of imports has a ily appreciated by noting that a $25 billong-run rising trend, the change in the lion annual loss is equivalent to a loss terms of trade might temporarily reduce of about $100 per person per year, or to the volume of imports, causing the loss a 6.5 percent increase in personal to be smaller than estimated here. income tax payments. A $100 billion An alternative to using the long-run loss is equivalent to about $400 per person or a 27 percent tax increase.' terms-of-trade-change estimate given Although these calculations reveal above is to use direct evidence on the that a large deterioration in the terms degree to which depreciation is passed through by U.S. and foreign exporters. of trade entails a large loss to this Recent studies of previous episodes of - nation, it is also true that a dollar appreciation, such as occurred in the early changes in dollar exchange rates found 1980's, implies an improvement in the that foreign firms cut the foreign currency prices of their exports by 20 perterms of trade and a large gain for the cent of a depreciation and pass through nation. The worsening in the terms of trade estimated here can be viewed as the other 80 percent of a depreciation into higher dollar prices charged to U.S. merely reversing some previous improveimporters; U.S. exporters, in contrast, ment, or it can be viewed as persisting pass through only 50 percent of a depre- only until some possible future improvement. However one chooses to view it, ciation, absorbing the other 50 percent the fact remains that the loss would in higher dollar prices for their exports.' If this pattern is repeated in the latest not have occurred if the dollar had not depreciated, and the loss will persist depreciation, the terms of trade would until a subsequent improvement in the terms of trade, if any, occurs. 3. Actually, the funds will come from 'both debt and equity transactions, but that does not change the argument so, for ease of exposition, we regard all as coming from debt. 5. If the initial terms of trade = 100%/100% = I, then assuming a 1.0% depreciation, the new terms of trade would be 100.5%1100.8% = 0.997. Thus, the terms of trade deteriorate by 1-0.997 = 0.003 = 0.3% for each 1.0% of depreciation. 4. Five studies are cited in Robert A. Feldman, "Dollar Appreciation, Foreign Trade, and the U.S. Economy," Federal Reserve Bank of New York Quarterly Review, Summer 1982, p. 5. 6. If the initial terms of trade = 100%/100% and the new terms of trade = 103%/118% = 0.873, then the deterioration is 1-0.873 or 0.127 = 12.7%. = I, Change in Value of U.S. International Assets and Liabilities At the end of 1984, just before the dollar began to depreciate, foreign-held assets in the United States, and U.S. holdings abroad, were roughly in balance-$892 billion and $885 billion, respectively (see table 1).8 In 1985 and 1986, foreign assets in the United States increased by $439 billion and U.S. assets abroad increased by $172 billion, leaving the United States a net debtor of approximately $274 billion. U.S. assets abroad are potential claims on foreign goods that the United States could import, and foreign assets in the United States are potential foreign claims on U.S. export goods. The values of assets here and abroad, measured in the sense of being potential claims on exports and imports, are altered by the changes in export and import prices that accompany dollar depreciation. Although they too could be considered potential claims on foreign goods, U.S. assets in the United States are excluded from the following calculations because they are different from U. S. assets abroad in that they are not liabilities of foreign residents. Similarly, foreign assets abroad are excluded from the calculations because they are not liabilities of U.S. residents. Most of the assets that foreigners hold in the United States are dollardenominated financial instruments such as bonds, loans, and bank deposits. The others are mostly corporate stocks and direct investments that have no currency denomination, but that can be considered to be denominated in dollars because they are claims on dollardenominated income streams. Dollar depreciation reduces the value of assets in the United States owned by foreigners, measured in their own currencies. However, the foreigners' real loss from dollar depreciation, and thus the real gain for the United States, occurs because, as discussed earlier, depreciation leads to rises in the dollar prices of U.S. exports that cause the foreigners' holdings of dollars to represent a potential claim on fewer U.S. goods. About three-fifths of the assets that U.S. residents hold abroad also are primarily financial instruments denominat- 7. The U.S. loss from a worsening of the terms of trade is distributed unevenly among U.S. residents. Consumers of imported products lose because they must pay higher prices, but U.S. producers who compete against foreign goods here or abroad gain from increased profit margins. Table 1 Foreign Assets in the United States and U.S. Assets Abroad" (billions of dollars, end of year) Changes 1984 1984 1985 to to 1985 1986 1985 1986 Foreign Assets in the 1,061 892 United States (line 20) U.S. Assets Abroad Excluding Gold 885 938 (line 2 less line 4) Denominated in or Saleable for Foreign 313 356 Currencies (lines 5, 6, 7, 11, 12, 14, and 17 plus half of lines 16 and 18) Denominated in Dollars 572 582 (lines 10 and 19, plus half of lines 16 and 18) 1,331 169 270 1,057 53 119 407 43 51 650 10 68 *Notes: Where necessary, the author has made assumptions about the currency denomination of certain items. Gold is excluded from U.S. Assets Abroad for reasons given in footnote 8. Basic data are from lines indicated in Survey 0/ Current Business, June 1987, page 40, table 2. ed in dollars. A much smaller amount, primarily certain official reserve assets, are denominated in foreign currencies. The rest are mostly corporate stocks and direct investments and therefore have no currency denomination, but they can be considered to be denominated in foreign currencies because they are claims on foreign-currencydenominated income streams. The dollar value of dollar-denominated assets abroad owned by U.S. residents is not affected by depreciation. However, the dollar value represents a claim on fewer foreign goods after depreciation than before because depreciation raises the dollar prices of foreign goods. On the other hand, U.S. assets abroad denominated in foreign currencies represent a larger claim on foreign goods after depreciation than before because dollar depreciation is accompanied by a reduction in the foreign-currency price of foreign goods. To estimate the U.S. gain or loss caused by dollar depreciation's effect on the potential purchasing power of the United States' international assets and liabilities, we can assume that the present depreciation will be passed through into import and export prices in the same proportions as in the past, that is, U.S. export prices rise by 50 percent of the depreciation, U.S. import dollar prices rise by 80 percent of the depreciation, and U.S. import foreign currency prices fall by 20 percent of the depreciation. The estimate of gain or loss to U.S. residents is made in four steps. First, foreigners held $892 billion of dollar-denominated assets in the United States at the end of 1984 (see table 1). Assuming that 50 percent of the dollar's depreciation is absorbed in higher dollar prices for U.S. exports, the change in price of U.S. exports resulting from the dollar's 37 percent depreciation between first quarter 1985 and third quarter 1987 is 18.5 percent. That reduces the real value of those assets, measured in terms of their potential claim on U.S. exports, from $892 billion to $753 billion ($892 billion -;- 1.185), a reduction of $139 billion. This is a gain for the United States. Second, U.S. residents held $572 billion of dollar-denominated assets abroad at the end of 1984. Assuming that foreign firms pass through 80 percent of the depreciation into higher dollar prices, the dollar's 37 percent depreciation raises import dollar prices by 29.6 percent. That reduces the real value of those assets, measured in terms of their potential claim on foreign exports, from 8. Gold has been excluded from these figures. Although gold held by the U.S. government is listed as a U. S. asset abroad in reports of the international investment position of the United States, that treatment is a carryover from the time when gold played an important role in the international monetary system. While gold is still an important asset of the U. S. government, it need not be considered a U. S. asset abroad. Indeed, if it were to be considered as a U. S. asset abroad, it is unclear whether it should be considered to be denominated in dollars, whose purchasing power has decreased, or denominated in foreign currency, whose purchasing power has increased. Moreover, gold is different from other U. S. assets abroad in that it is not a liability of a foreign resident. of the situation to improve their profit margins by raising the dollar prices they charge. In such a case, there is also less than full pass-through of the dollar depreciation to the foreign-currency prices that foreigners pay for U.S. goods. The degree to which a depreciation is passed through as price changes, both in export and import markets, depends on how sensitive producers and consumers are to price changes - in other words, on the supply and demand elasticities for exports and imports. These elasticities will differ among products and will depend on many aspects of the market situation, including sellers' profit margins, the amount of idle capacity in the particular industry, expectations regarding the permanence of the exchange-rate change, the degree of competition, the terms of existing contracts between buyer and seller, and the strength of the buyers' demand for the product. Elasticities are usually larger in the long run than in the short run because buyers and sellers have more time to react. An estimate of the long-run terms-oftrade effect of dollar depreciation, calculated using econometric estimates of the supply and demand elasticities of U.S. imports and exports, indicates that for every 1 percent depreciation of the dollar, the U.S. terms of trade would deteriorate by 0.76 percent in the long run." This means that the physical amount of imports that the U.S. can purchase with the proceeds from a given physical amount of exports declines by about three-quarters of a percent for each 1 percent depreciation of the dollar. The dollar depreciated by a weighted average of about 37 percent against other major currencies between the first quarter of 1985 and the third quarter of 1987, and was continuing to fall in the fourth quarter. If the longrun relationship cited above holds, the 37 percent depreciation will eventually translate into a 28 percent worsening in the terms of trade. U.S. exports in 1985 and 1986 averaged $215 billion. Thus it appears that one cost of the dollar depreciation, imposed through a deterioration in the terms of trade, could eventually reach 28 percent of $215 billion, or about $60 billion per year. That is, because dollar deteriorate by 0.3 percent for each 1 depreciation leads to larger increases in percent depreciation of the dollar." In the dollar prices of imported goods than this case, the 37 percent depreciation in the dollar prices of exported goods, would cause an 11.1 percent drop in the the revenue from a given physical terms of trade (0.3 x 37%). The cost to quantity of goods exported after the the United States, measured in terms depreciation will, on average, purchase of the reduced real purchasing power of a smaller physical quantity of imports U.S_ exports, would be $24 billion per year (11.1% x $215 billion). The cost, than before the depreciation. The loss to the nation is the reduction in the measured in terms of the increased real physical quantity of imports earned by cost of imports, would be $40 billion per year (11.1% x $358 billion). exporting. This cost will continue year after year and will grow as the volume An alternative calculation yields simof exports grows. ilar results. That approach is to examine The loss calculation described above the actual change in terms of trade thus is conservative in that it ignores the far in the current episode of dollar defact that U.S. imports exceeded U.S. preciation. Since the dollar began its exports by an average of $143 billion in depreciation in early 1985, import 1985 and 1986. Imports that the U.S. is prices have risen much faster than exunable to finance with current export port prices. Between March 1985 and earnings are, in essence, purchased September 1987, prices of imports, with funds borrowed from foreigners." excluding fuels, rose about 18 percent while prices of exports rose only about If these loans are repaid, it is likely to be with the proceeds of future exports. 3 percent. Thus, the terms of trade Thus, imports are being purchased with have worsened by about 12.7 percent so current and future exports. The loss far." In the long run, of course, the from the worsening in the terms of terms of trade may worsen further or trade can be calculated to be the reverse some of their deterioration. If increase in the volume of exports they don't change, however, the annual needed, now or later, to pay for an cost to the nation would either be $27 unchanged volume of imports. U.S. billion (12.7% x $215 billion), or $45 billion (12.7% x $358 billion). imports in 1985 and 1986averaged $358 billion, so the loss is 28 percent of $358 The importance to the United States billion or about $100 billion per year. of these annual losses can be more easAlthough the volume of imports has a ily appreciated by noting that a $25 billong-run rising trend, the change in the lion annual loss is equivalent to a loss terms of trade might temporarily reduce of about $100 per person per year, or to the volume of imports, causing the loss a 6.5 percent increase in personal to be smaller than estimated here. income tax payments. A $100 billion An alternative to using the long-run loss is equivalent to about $400 per person or a 27 percent tax increase.' terms-of-trade-change estimate given Although these calculations reveal above is to use direct evidence on the that a large deterioration in the terms degree to which depreciation is passed through by U.S. and foreign exporters. of trade entails a large loss to this Recent studies of previous episodes of - nation, it is also true that a dollar appreciation, such as occurred in the early changes in dollar exchange rates found 1980's, implies an improvement in the that foreign firms cut the foreign currency prices of their exports by 20 perterms of trade and a large gain for the cent of a depreciation and pass through nation. The worsening in the terms of trade estimated here can be viewed as the other 80 percent of a depreciation into higher dollar prices charged to U.S. merely reversing some previous improveimporters; U.S. exporters, in contrast, ment, or it can be viewed as persisting pass through only 50 percent of a depre- only until some possible future improvement. However one chooses to view it, ciation, absorbing the other 50 percent the fact remains that the loss would in higher dollar prices for their exports.' If this pattern is repeated in the latest not have occurred if the dollar had not depreciated, and the loss will persist depreciation, the terms of trade would until a subsequent improvement in the terms of trade, if any, occurs. 3. Actually, the funds will come from 'both debt and equity transactions, but that does not change the argument so, for ease of exposition, we regard all as coming from debt. 5. If the initial terms of trade = 100%/100% = I, then assuming a 1.0% depreciation, the new terms of trade would be 100.5%1100.8% = 0.997. Thus, the terms of trade deteriorate by 1-0.997 = 0.003 = 0.3% for each 1.0% of depreciation. 4. Five studies are cited in Robert A. Feldman, "Dollar Appreciation, Foreign Trade, and the U.S. Economy," Federal Reserve Bank of New York Quarterly Review, Summer 1982, p. 5. 6. If the initial terms of trade = 100%/100% and the new terms of trade = 103%/118% = 0.873, then the deterioration is 1-0.873 or 0.127 = 12.7%. = I, Change in Value of U.S. International Assets and Liabilities At the end of 1984, just before the dollar began to depreciate, foreign-held assets in the United States, and U.S. holdings abroad, were roughly in balance-$892 billion and $885 billion, respectively (see table 1).8 In 1985 and 1986, foreign assets in the United States increased by $439 billion and U.S. assets abroad increased by $172 billion, leaving the United States a net debtor of approximately $274 billion. U.S. assets abroad are potential claims on foreign goods that the United States could import, and foreign assets in the United States are potential foreign claims on U.S. export goods. The values of assets here and abroad, measured in the sense of being potential claims on exports and imports, are altered by the changes in export and import prices that accompany dollar depreciation. Although they too could be considered potential claims on foreign goods, U.S. assets in the United States are excluded from the following calculations because they are different from U. S. assets abroad in that they are not liabilities of foreign residents. Similarly, foreign assets abroad are excluded from the calculations because they are not liabilities of U.S. residents. Most of the assets that foreigners hold in the United States are dollardenominated financial instruments such as bonds, loans, and bank deposits. The others are mostly corporate stocks and direct investments that have no currency denomination, but that can be considered to be denominated in dollars because they are claims on dollardenominated income streams. Dollar depreciation reduces the value of assets in the United States owned by foreigners, measured in their own currencies. However, the foreigners' real loss from dollar depreciation, and thus the real gain for the United States, occurs because, as discussed earlier, depreciation leads to rises in the dollar prices of U.S. exports that cause the foreigners' holdings of dollars to represent a potential claim on fewer U.S. goods. About three-fifths of the assets that U.S. residents hold abroad also are primarily financial instruments denominat- 7. The U.S. loss from a worsening of the terms of trade is distributed unevenly among U.S. residents. Consumers of imported products lose because they must pay higher prices, but U.S. producers who compete against foreign goods here or abroad gain from increased profit margins. Table 1 Foreign Assets in the United States and U.S. Assets Abroad" (billions of dollars, end of year) Changes 1984 1984 1985 to to 1985 1986 1985 1986 Foreign Assets in the 1,061 892 United States (line 20) U.S. Assets Abroad Excluding Gold 885 938 (line 2 less line 4) Denominated in or Saleable for Foreign 313 356 Currencies (lines 5, 6, 7, 11, 12, 14, and 17 plus half of lines 16 and 18) Denominated in Dollars 572 582 (lines 10 and 19, plus half of lines 16 and 18) 1,331 169 270 1,057 53 119 407 43 51 650 10 68 *Notes: Where necessary, the author has made assumptions about the currency denomination of certain items. Gold is excluded from U.S. Assets Abroad for reasons given in footnote 8. Basic data are from lines indicated in Survey 0/ Current Business, June 1987, page 40, table 2. ed in dollars. A much smaller amount, primarily certain official reserve assets, are denominated in foreign currencies. The rest are mostly corporate stocks and direct investments and therefore have no currency denomination, but they can be considered to be denominated in foreign currencies because they are claims on foreign-currencydenominated income streams. The dollar value of dollar-denominated assets abroad owned by U.S. residents is not affected by depreciation. However, the dollar value represents a claim on fewer foreign goods after depreciation than before because depreciation raises the dollar prices of foreign goods. On the other hand, U.S. assets abroad denominated in foreign currencies represent a larger claim on foreign goods after depreciation than before because dollar depreciation is accompanied by a reduction in the foreign-currency price of foreign goods. To estimate the U.S. gain or loss caused by dollar depreciation's effect on the potential purchasing power of the United States' international assets and liabilities, we can assume that the present depreciation will be passed through into import and export prices in the same proportions as in the past, that is, U.S. export prices rise by 50 percent of the depreciation, U.S. import dollar prices rise by 80 percent of the depreciation, and U.S. import foreign currency prices fall by 20 percent of the depreciation. The estimate of gain or loss to U.S. residents is made in four steps. First, foreigners held $892 billion of dollar-denominated assets in the United States at the end of 1984 (see table 1). Assuming that 50 percent of the dollar's depreciation is absorbed in higher dollar prices for U.S. exports, the change in price of U.S. exports resulting from the dollar's 37 percent depreciation between first quarter 1985 and third quarter 1987 is 18.5 percent. That reduces the real value of those assets, measured in terms of their potential claim on U.S. exports, from $892 billion to $753 billion ($892 billion -;- 1.185), a reduction of $139 billion. This is a gain for the United States. Second, U.S. residents held $572 billion of dollar-denominated assets abroad at the end of 1984. Assuming that foreign firms pass through 80 percent of the depreciation into higher dollar prices, the dollar's 37 percent depreciation raises import dollar prices by 29.6 percent. That reduces the real value of those assets, measured in terms of their potential claim on foreign exports, from 8. Gold has been excluded from these figures. Although gold held by the U.S. government is listed as a U. S. asset abroad in reports of the international investment position of the United States, that treatment is a carryover from the time when gold played an important role in the international monetary system. While gold is still an important asset of the U. S. government, it need not be considered a U. S. asset abroad. Indeed, if it were to be considered as a U. S. asset abroad, it is unclear whether it should be considered to be denominated in dollars, whose purchasing power has decreased, or denominated in foreign currency, whose purchasing power has increased. Moreover, gold is different from other U. S. assets abroad in that it is not a liability of a foreign resident. $572 billion to $441 billion ($572 billion + 1.296), a reduction of $131 billion. This is a loss for the United States. Third, U.S. residents also held $313 billion equivalent of assets abroad denominated in foreign currencies. If foreign currency prices of U.S. imports fall by 20 percent of the dollar's depreciation, as discussed above, those import prices will fall by 7.4 percent. That price decline boosts the real value of those assets from $313 billion to $313 billion divided by (1-.074), an increase of $25 billion. This is a gain for the United States. In total, we can estimate that the dollar's 37 percent devaluation has decreased the real value of U.S. international assets $106 billion ($25 billion - $131 billion), and decreased the real value of U.S. internationalliabilities by $139 billion, for a net real gain to the United States of $33 billion. The calculationsabove are based on the effect of dollar depreciation since first quarter 1985 on asset positions at the end of 1984. The fourth step in the estimate takes account of the fact that there have been large additions to U.S. assets abroad and foreign assets in the United States since the end of 1984 that represent additional potential claims on U.S. and foreign goods (see table 1). The gains and losses on these additional assets here and abroad, caused by dollar depreciation, must be calculated separately in order to consider only the portion of the depreciation that occurred after the assets were accrued. The values of the assets here and abroad 9. Investors who expect dollar depreciation will, if possible, demand higher nominal returns on their international assets to compensate them for expected losses from depreciation; investors who 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. that accrued in 1985 are considered here to be changed only by dollar depreciation that occurred after fourth quarter 1985, and assets here and abroad that accrued in 1986 are considered here to be affected only by dollar depreciation that occurred after fourth quarter 1986. Calculations similar to those above indicate that the depreciation has given the United States a net gain of $18 billion on the accruals to assets that occurred in 1985. On accruals in 1986, the U.S. net gain was $7 billion. Taken together, the $33 billion gain, the $18 billion gain, and the $7 billion gain add to a total one-time gain for the United States of $58 billion." An alternative calculation of the changed potential claims on U.S. and foreign exports, made using actual changes in export and import prices, indicates a net one-time gain for the United States of $32 billion. Conclusions The dollar's 37 percent depreciation between the first quarter of 1985 and the third quarter of 1987 worsened our terms of trade, causing a continuing annual real loss to the nation estimated to be between $24 billion and $100 billion. This annual loss will grow as the volume of trade grows. The ann ual loss will be partially offset by the one-time gain from the dollar depreciation's effect on the potential purchasing power of U.S. expect to gain from depreciation will accept lower nominal returns, if necessary. Such adjustments in nominal returns will mitigate the gains and losses and reduce the net gain to the United States from changes in the value of U.S. interna- international assets and liabilities, which we have estimated to be between $32 billion and $58 billion. Comparing the midpoint of the range of annual loss estimates, $62 billion, to the midpoint of the one-time gain estimates of about $45 billion, we can see that the onetime gain will be offset by the annual losses in less than a year, after which the losses will continue to accrue, year after year. Although a reduction in the terms of trade is costly, that cost may be unavoidable if the United States is to reduce its trade deficit. A reduction of the trade deficit is generally considered desirable because it will reduce the need for the United States to import capital and thus to increase its net international indebtedness, and also because reduction of the trade deficit is generally believed to stimulate domestic production and employment. Of course, faster growth of the economies of our major trading partners would tend to reduce the U.S. trade deficit without a worsening of the terms of trade. However, foreign governments may be reluctant to stimulate their economies if they expect such action to be inflationary and, in any event, faster foreign growth is unlikely to fully eliminate the trade deficit. Slower growth of the U.S. economy also would tend to reduce the U.S. trade deficit, but that is, of course, an undesirable method of improving the trade balance. tional assets and liabilities. However, most asset holders are locked into nominal returns that they cannot alter when depreciation occurs, so the offset here will be only partial. 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 October 15, 1987 ISSN 0428·1276 iECONOMIC COMMENTARY The foreign-exchange value of the dollar has been depreciating for more than two-and-a-half years. Most discussion about this depreciation has focused on traditional issues, such as its effects on the overall trade balance, economic growth, import prices, inflation, and interest rates.' Some other important effects, however, have generally been overlooked. Dollar depreciation, for example, is supposed to improve the U.S. trade balance partly by increasing the cost of foreign goods, thus reducing the volume of imports by making them less attractive to consumers. Higher import prices, however, will have a significant real cost to the nation. The resources the United States would have to expend to purchase a given volume of imports would increase. Only if the prices of U.S. export goods also increased, so that there were greater export earnings from a given volume of exports to help pay the higher import bill, would some of this higher cost be offset. There has been practically no public discussion of the import cost increase, nor attempts to measure it, despite the fact that the net cost to the United States is potentially large. Failure to reduce the trade deficit is also costly, however, in the sense that it implies continued growth of U.S. net indebtedness to foreigners. This trend, in contrast, has received much public attention. Another potential implication resulting from dollar depreciation centers on the foreign assets owned by U.S. citizens, and on the debts that Americans owe to foreigners. Depending on the currencies in which they are denominated, the values of these assets and liabilities will either be increased or decreased by dollar depreciation. But again, there has been little public discussion of this effect of depreciation. This Economic Commentary discusses and estimates the costs and benefits that dollar depreciation imposes through changes in the prices of imports and exports, and the costs and benefits imposed through changes in the potential purchasing power of U.S. international assets and liabilities. Because of inadequacies in the data and uncertainty about which are the best concepts of the gains and losses, a range of estimates is presented. Despite their lack of precision, the estimates nevertheless indicate the signs and general magnitudes of these gains and losses, and help round out public discussion of the costs and benefits of dollar depreciation. It is not the purpose of this presentation, however, to argue that dollar depreciation is either good or bad. Such a judgement must be based on an evaluation of all of the effects of depreciation, not just on the net loss that is calculated here. Such an overall evaluation is beyond the scope of this essay. Gerald H. Anderson is an economic advisor at the Federal Reserve Bank of Cleveland. The author would like to thank John Scadding, Mark Sniderman, and EJ Stevens for 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. 1. For a discussion of these traditional issues, see Gerald H. Anderson, "Is Dollar Depreciation Desirable?," Economic Commentary, December IS, 1985. Change in Terms of Trade The terms of trade is a measure indicating the amount of imports that can be purchased with a unit of exports. It can be described as the ratio of the prices a nation receives for its exports to the prices it pays for its imports, with all prices measured in the same 2. The equation for calculating the responsiveness of the terms of trade to a change in exchange rates is given in H. Robert Heller, Inter- Two Neglected Implications of Dollar Depreciation by Gerald H. Anderson currency. A decrease in this ratio would be considered a deterioration in the nation's terms of trade: the nation would be worse off economically after the decrease because its exports would have less buying power. A terms-of-trade loss is not the same as a reduction in a nation's real gross national product (GNP). Real GNP might be unchanged, but a nation with a terms-of-trade loss would still be worse off because a given physical quantity of its goods can now be traded for only a smaller amount of foreign goods. Thus, even if the nation's production of goods and services did not change, the resources it would have available for consumption, investment, and government would be smaller because its exchanges of goods with other nations would be on lessfavorable terms. The amount by which dollar depreciation changes the prices of U.S. imports and exports depends on the size of the depreciation and on the extent to which U.S. and foreign exporters try to offset its effects. A foreign exporter, of Japanese cars, for example, could cushion some of the impact of a dollar decline on its sales by cutting the yen price of an automobile. As a result, the dollar price to U.S. importers will not rise by the full extent of the dollar's depreciation. In this case, there is less than full "pass-through" of the depreciation to import prices because the Japanese exporter has been willing to shave his profit margin. By the same token, U.S. exporters, finding themselves in a more competitive position because of the dollar's depreciation, may take advantage national Monetary Economics, 1974, Prentice Hall, Inc., Englewood Cliffs, N.J., page 101. Estimates of supply and demand elasticities of U.S. exports and imports are summarized in the Handbook of International Economics, Volume 2, North Holland Publishing Company, 1985, pages 1078, 1079, 1087, and 1088.
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