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August 12, 1977
M ore on the Dollar
The recent troubles of the dollar
have reminded some observers of
the nervous days of the early 1970's
when currency "crises" enlivened
the days and nights of central bankers. Yet a good deal has been
learned, or perhaps re-Iearned,
since that time about the determinants of exchange-rate behavior.
We know that rates are fundamentally determined by the relative
quantities of national money supplies in conjunction with relative
national rates of economic growth.
Where money growth rates exceed
the growth of available domestic
goods, the resultant excesssupply
of domestic money leads to increased purchases of foreign goods
and assets-which situation then
tends to bring
a depreciation
of the currency. This proposition
was demonstrated in the wake of
the December 1971 Smithsonian
agreement. Despite the existence
of a structure of nominally "fixed"
exchange rates, sharp variations in
national fiscal and monetary policies made it impossible to maintain
the Smithsonian rates after February 1973.
Of course, changes in net demand
for foreign goods and assets,which
are not proximately related to such
fundamentals as the behavior of the
money stock or real output, can
alter demand or supply conditions
in foreign-exchange markets on a
day-to-day or even a month-tomonth basis.Thus, in view of the
absence of any change in
exchange-rate "fundamentals," we
must look to these other factors in
order to explain the dollar's recent
gyrations. Indeed, it could be argued that the earlier conjunction of
a steady dollar and record trade
deficits could only be explained in
terms of a high level of capital
inflows, and similarly, that the more
recent depreciation of the dollar
could be explained in terms of a
reduced level of such inflows.
Shift in capital flows
This shift in U.S. capital inflows had
been foreshadowed by late-1976
monetary developments. For 1976
as a whole, the IMF's index of u.s.
liabilities to official foreigners rose
by about $11.0 billion, while the
comparable figure for private foreigners indicated investment of
about $13.5 billion. But during the
first quarter of 1977,the same measure of foreign official capital inflows stood at an $18.2billion annual rate, while inflows from private
sources abroad were running at a
negative annual rate of $17.2 billion. This sharp reversal of private
capital flows may have reflected
some anticipated weakness of the
dollar in the wake of the fourth
quarter's rapid rate of U.S. monetary expansion, when the broadly
defined (M 2) money supply grew at
an annual rate of 13.1 percent.
Thus, with the deficit continuing
and private funds flowing overseas,
the dollar became highly vulnerable to depreciation by the end of
the first quarter of 1977.
(continued on page 2)
OlJinions expressed in this newsletter do not
necessarily reflect the views of the management of the
Federal Reserve Bank of San Francisco, nor of the Board
of Governors of the Federal Reserve System.
Following this April's upsurge in the
U.S. money supply, when the M 2
aggregate grew at a 14.4-percent
annual rate} private concern about
the dollar probably increased} and
foreign central banks found themselves under greater pressure to
prevent an appreciation of their
currencies against the dollar. The
emphasis by some officials on the
benefits of "virtuous deficits," and
their apparent unconcern about a
possible depreciation in the value
of the dollar} may have convinced
foreign central banks that further
attempts to resist dollar depreciation would require intervention on
a scale that would produce considerable inflationary pressure at
home. In any case,the dollar would
depreciate whenever the level of
intervention} relative to a combination of capital inflows and the trade
balance, was allowed to fall.
The July depreciation of the dollar
has been partially reversed and} in
the absence of any new evidence of
a more expansionary U.S. policy
posture, is unlikely to be resumed.
After all} those countries whose
currencies have appreciated against
the dollar-Germany, Japan and
Switzerland-already face rising
pressuresat home to lower unemployment. These pressuresto create
jobs, along with the usual pressures
to expand exports, suggest severe
constraints upon the degree of dollar depreciation which those countries might be willing to accept.
Tradersand the dollar
Some observers have argued that
this latest episode of dollar depreciation represents another example
of over-reaction on the part of
2
skittish traders-evidenced by the
fact that, despite "fundamentals,"
the U.S. dollar at times even weakened against such traditionally
"weaker" currencies as the pound
sterling and the French franc. However, this argument may be misleading. It overlooks the fact that
dollar exchange rates are a set of
simultaneously determined prices,
. each of which must be consistent
with an entire array of non-dollar
cross rates.
The dollar will depreciate against}
say, sterling whenever it depreciates faster against some third currency} like the yen, than sterling
depreciates against the yen. In such
a case} arbitrageurs will insure that
the dollar depreciates against sterling by converting yen into dollars
and then selling the dollars to buy
sterling, until such triangular arbitrage aligns the direct dollar price
of sterling with the implicit yen
price of sterling and dollars, as well
as with the implicit prices of all
other "third currencies" in terms of
sterling and dollars. On any given
day} a rise in the dollar price of
some third currency could exceed a
. rise in the sterling or French franc
price of that same third currency}
especially in view of an official intervention policy aimed at maintaining bilateral dollar-exchange
rates. Such an event reflects no
overreaction of the exchange markets. Rather it simply reflects the
efficiency of arbitrageurs in maintaining the overall consistency of
exchange rates.
Domestic implications
Any decline of the dollar, if not
subsequently reversed} will of
course have tangible implications
for U.S. producers and consumers.
To the extent that a higher dollar
price of foreign currencies causesa
change ih relative prices, U.S. producers of exports and import substitutes will experience an increase
in demand for their products. However, this increased demand-and
the attendant increase in
employment-occur only when the
depreciation involves a sustainable
new equilibrium set of exchange
rates. In many casesin the past,
expansionary domestic policies
have offset the reduction of domestic consumption required to
keep sales of goods abroad above
the amounts purchased abroad.
imported goods. It would, however, be a mistake to conclude from
this that currency depreciation
causesinflation. Rather the depreciation simply describes the inflation. Both the rise in the dollar
price of domestic goods and the
rise in the dollar price of foreign
goods are symptoms of a net excess
supply of dollars. In the recent case,
the inflationary impact of higherpriced imports has only been delayed by heavy purchases of U.S.
dollars by foreign governments. In
any event, the dollar could well
stabilize in the months aheadalthough appreciating against some
currencies and depreciating against
others-given the achievement of
current U.S. money growth targets
and the absence of major shocks
abroad.
John H. Makin
For U.S. consumers, currency depreciation means a rise in prices of
Depreciation (%)
10
11
12
I',
13
14
$ Billions
'>
(Annual
15
20
Capital ....
15
rate)
10
16
5
17
o
18
- 5
-10
-15
• Change in trade- weighted
exchange rate since June 1970
III
IV
1975
Source: International FinancialStatistics
3
III
1976
IV
III
1977
IV
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{}
BANKING DATA-TWELFTH flEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand liabilities
large Commercial Banks
Amount
Outstanding
7127177
98,742
76,144
1,790
23,658
24,626
13,208
8,747
13,851
97,298
27,781
350
67,379
5,632
31,992
27,779
10,337
Weekly Averages
of Daily Figures
Week ended
+
+
+
+
+
+
+
+
+
7/27177
10
8
18
Change from
year ago
Dollar
Percent
7120177
+
+
Loans (gross, adjusted) arid investments*
Loans (gross, adjusted)-total
Security loans
Commercial and industrial
Real estate
Consumer instalment
U.S. Treasury securities
Other securities
Deposits (less cash items)-total*
Demand deposits (adjusted)
U.S. Government deposits
Time deposits-total*
States and political subdivisions
Savingsdeposits
Other time deposits:j:
Large negotiable CD's
Member Bank Reserve Position
ExcessReserves(+)/Deficiency H
Borrowings
Net free(+)/Net borrowed (-)
Federal Funds-Seven large Banks
Interbank Federal fund transactions
Net purchases (+)/Net sales(-)
Transactions with U.S. security dealers
Net loans (+)/Net borrowings H
Change
from
269
373
44
85
134
68
35
69
161
65
119
337
13
45
232
263 .
+
+
+
+
+
+
+
+
+
+
-
+
+
-
Week ended
7120177
+
+
153
152
+
+
+
+
+
+
+
-
+
+
+ 1 )64
+
-
11.82
14.27
37.38
9.41
20.45
16.41
7.18
13.09
9.43
10.83
4.63
8.69
6.85
20.45
2.84
10.38
'Comparable
year-ago period
74
6
68
+
+
+
+
+
+
+
10,437
9,511
487
2,034
4,181
1,862
677
1,603
8,381
2,715
17
5,388
414
5,431
767
1,197
244
69
1
68
121
+
18
*Includes items not shown separately. :j:lndividuals, partnerships and corporations.
Editorial comments may be addressed to the editor (William Burke) or to the author . •••
Information on this and other publications can be obtained by calling or writing the Public
Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 544-2184.
@FedFRASER