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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

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Research Department
P.O. Box 6387
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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.

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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
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P.O. Box 6387
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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.

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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.