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FRBSF

WEEKLY LETTEA

Number 92-35, October 9, 1992

The Dollar: Shoit-Run Volatility
and Long-Run Adjustment
The foreign exchange value of the dollar is relatively volatile because, like otherfinancial assets,
its value in the short run is determined by forwardlooking expectations. Ultimately, these expectations should tend to be consistent with fundamental
economic factors. But economists have had difficulty in identifying the relative importance of
these fundamentals, especially for the dollar.
Indeed, a widely held view is that existing economic models of the dollar cannot predict its
movements any better than can a naive model
that simply assumes no change.
This Weekly Letter reports on some new research
on this issue (Throop, 1992). This research shows
that the adjustment of the dollar's value to fundamental economic factors is an important part of
its short-run movements. Moreover, a model that
takes this adjustment into account predicts the
dollar's value significantly better than does a
model of no change.
Long-run fundamentals
The model of the dollar focuses on its real tradeweighted value, which incorporates values of the
major currencies with which we trade. The real
trade-weighted value of the dollar is obtained by
multiplying its nominal trade-weighted value in
terms of foreign currencies times the ratio of the
u.s. price level to the foreign trade-weighted
price level The higher the real value of the dollar,
the greater its relative purchasing power of foreign
goods and services. Four factors-productivity,
oil prices, budget deficits, and long-term interest
rates-primarily affect the real value of the dollar
(see Chart 1). Each is discussed in turn.

1. Productivity. Other things being equal, the
exchange rate tends to adjust so as to equalize
prices of traded goods at home and abroad in the
same currency. This tends to keep the real exchange rate constant when measured in terms of
the prices of the traded goods. But the real tradeweighted dollar is measured in terms of overall

price levels-that is, it includes the prices of
non-traded goods as well. So if productivity in
traded goods relative to all goods were to grow

more slowly in the u.s. than abroad, the real
value of the dollar measured in terms of overall
price levels would decline.

Chart 1
Contributions of Fundamental
Economic Factors to Real Value
of the Dollar (in logarithms)
0.4

0.8
Productivity -

0.6
0.4 ../

0.2
0.0

.

-

;••••••~....

.

4·..

0.2

..

:
Bond Rate
Differential

'.,

0.0

-0.2

U.S. Budget
Deficit

-0.2 .' .

.

~------'" ·0.4

. : ..... ;'.... '. -0.6

.

~~

\,

Oil Price
-0 A'---'--I.-..L.-.J.-J-...l..-J'--'--'-.l..-L-L--'--'--'--'--'--' -0.8
75 77 79 81 83 85 87 89 91

Prices of traded goods can be proxied by wholesale prices, while the overall price level is approximated by consumer prices. In the 1970s,
productivity growth in U.s. traded goods relative
to all goods tended to lag that abroad. As shown
in Chart 1, in the latter half of the 1970s this factor
is estimated to have contributed to a significant
depreciation in the real trade-weighted value of
the u.s. dollar. But in the 1980s this factor accounted for relatively little change in the dollar's
value.

2. Real Price of Oil. Economies differ with respect
to their dependence on imported oil. Although
the U.S. imports about 40 percent of its oil requirements, it is less dependent on foreign oil
than most of its major trading partners. As a
result, when the real price of oil rises, the real
value of the U.S. dollar tends to appreciate.
As shown in Chart 1, the sharp rise in the real
price of oil in the late 1970s and early 1980s is
estimated to have contributed significantly to

FRBSF
increasing the real value of the U.s. dollar. In
contrast, in 1986 a similar sharp decline in the
real price of oil reduced
competitiveness,
thus contributing to a sharp decline in the dollar's value.

u.s.

3. U.S. Budget Deficit. A larger U.S. budget deficit tends to put upward pressure on u.s. (and
ultimately foreign) interest rates and to draw capital in from abroad. Stronger foreign capital in
flows, in turn, work to appreciate the dollar. These
capital inflows, and hence a stronger dollar, will
persist even after u.s. and foreign interest rates
have equalized at a higher level. Although interest
will have to be paid to foreigners on the increased
indebtedness, which decreases the net demand for
dollars to some extent, the overall effect of budget
deficits is still to appreciate the dollar. In short,
budget deficits affect the value of the dollar independently from their effects on interest rates.

Short-run adjustment
Chart 2 shows the total estimated contributions
of all four fundamental economic factors to
movements in the real trade-weighted value of
the dollar in the period of floating exchange
rates. These four factors explain about 80 percent
of the (in-sample) variation in the real value of
the dollar in this period. Why do these four factors tend to explain the major swings in the
dollar's value but miss some of the minor ones?
The reason is that it takes times for the market to
perceive the long-run effects of the fundamental
economic factors; in other words, expectations
about the equilibrium value of the dollar-and
hence the dollar's current value-adjust only
gradually tochanges in these fundamentals.

Chart 2
Real Value of the Dollar

Chart 1 shows that rising U.s. budget deficits are
estimated to have contributed significantly to the
appreciation of the real value of the dollar in the
early 1980s.The u.s. government's larger demands
for capital generated persistently higher foreign
capital inflows, which tended to keep the dollar
relatively strong.
4. Real Long-Term Interest Rates. A final fundamental economic factor is the open interest parity
relationship; that is, the dollar's value will adjust
until the total expected return on assets denominated in dollars just equals the total expected
return on assets denominated in foreign currency,
plus or minus a risk premium. The expected
returns include not only pure interest returns, but
also the expected capital gains or losses arising
from anticipated changes in currency values. The
higher are real interest rates in the U.S. relative to
real interest rates abroad, the higher should be
the real value of the dollar-with an expected
depreciation to a long-run equilibrium value
determined by the other three fundamental
economic factors offsetting the higher interest
returns in the u.s.

Chart 1 shows that a falling differential between
and foreign real long-term interest rates contributed significantly to a falling value of the dollar in the late 1970s. The differential then rose
sharply in the first half of the 1980s and fell
almost equally sharply in the second half, contributing correspondingly to strength and then
weakness in the dollar.

u.s.

110

..
"

90

. .

Predicted····:
75

77

79

81

83

85

87

89

91

70

This adjustment may best be captured by an error correction model, in which a portion of the
difference between the dollar's actual value and
its equilibrium value determined by the fundamentals is eliminated each quarter. First, through
short-run open interest parity, the change in the
real value of the dollar. between the current quarter and the value expected for the next quarter
depends upon the real three-month interest rate
differential. Second, the value expected for the
next quarter is revised according to an error correction process, so that it gradually approaches
the equilibrium value determined by the four
fundamental economic factors.
Chart 3 shows the in-sample predictions of quarterly changes in the real trade-weighted value of
the dollar according to this model, which explain
about one half of their variation. According to
the estimated model, about 25 percent of the gap
between the equilibrium real value of the dollar

determined by economic fundamentals and its
actual value tends to be eliminated per quarter.
In addition, small "bandwagon effects" are present, with a 1 percent change in the dollar in the
previous quarter generating a % percent further
change in the same direction in the current
quarter.

Chart 3
Change in Real Value of the Dollar

Percent

10
5

o
-5

Predicted
'---'---L.....L.-;..;l--,--....r-.,..L......L--L...-,---,---,--,--,--,--....r-.,.I..-J

75

77

79

81

83

85

87

89

-1 0

91

tions to be made. The root mean squared error
of one-quarter-ahead predictions is 15 percent
lower than those obtained from the naive model.
For four and eight quarters ahead, the error is
33 and 60 percent lower, respectively.

Conclusions
This model of the dollar has some important implications for monetary policy. Previous research
has emphasized the role of real interest rate difand abroad in deterferentials between the
mining the real value of the dollar. However,
skeptics have pointed to the inability of such
models to hold up outside of the sample period
in which they were estimated. This model of the
dollar shows that real factors in addition to interest rates-namely productivity, the real price of
oil, and budget deficits-also playa significant
role. Moreover, this model holds up out of sample. But taking these additional factors into
account reduces the estimated effects of interest
rates on the dollar. As a result, I conclude that
the influence of monetary policy on the international sector of the economy, operating via
interest rates, probably is lower than previously

u.s.

thought.
Out-of-sample predictions are an importanttest

Adrian w. Throop
Research Officer

of a model because they use data other than that
on which the model was estimated. In contrast
to most economic models of the dollar, out-ofsample predictions of changes in the dollar with
this model (using actual values of the explanatory
variables) have substantially lower errors than
those obtained from a naive model of no change.
The model was first estimated for the period
1974.Q1 through 1981.Q4. Then predictions for
one, four, and eight quarters ahead of changes in
the dollar were made using the actual values of
the explanatory variables. The estimation was
then updated to include successively more quarters, allowing additional out-of-sample predic-

References
Meese, Richard. 1990./lCurrency Fluctuations in the
Post-Bretton Woods Era./I journal of Economic
Perspectives (Winter).
Throop, Adrian W. 1992. "A Generalized Uncovered
Interest Parity Model of Real Exchange Rates./I
Federal Reserve Bank of San Francisco, Working
Papers in Applied Econ<;)mic Theory, No. 92-04.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
Printed on recycled paper Q
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Index to Recent Issues of FRBSF Weekly Letter

DATE NUMBER TITLE
3/20
3/27
4/3
4/10
4/17
4/24
5/1
5/8
5/15
5/22
5/29
6/5
6/19
7/3
7/17
7/24
8/7
8/14
9/4
9/11
9/18
9/25
10/2

92-12
92-13
92-14
92-15
92-16
92-17
92-18
92-19
92-20
92-21
92-22
92-23
92-24
92-25
92-26
92-27
92-28
92-29
92-30
92-31
92-32
92-33
92-34

Foreign Direct Investment: Gift Horse or Trojan Horse?
U.s. International Trade and Competitiveness
Utah Bucks the Recession
Monetary Announcements: The Bank of japan and the Fed
Causes and Effects of Consumer Sentiment
California Banks' Problems Continue
Is a Bad Bank Always Bad?
An Unprecedented Slowdown?
Agricultural Production's Share of the Western Economy
Can Paradise Be Affordable?
The Silicon Valley Economy
EMU and the ECB
Perspective on California
Commercial Aerospace: Risks and Prospects
Low Inflation and Central Bank 'Independence
First Quarter Results: Good News, Bad News
Are Big U.s. Banks Big Enough?
What's Happening to Southern California?
Money, Credit,and M2
Pegging, Floating, and Price Stability: Lessons from Taiwan
Budget Rules and Monetary Union in Europe
The Slow Recovery
Ejido Reform and the NAFTA

AUTHOR
Kim
Glick
Cromwell
Hutchison/judd
Throop
Zimmerman
Neuberger
. Trehan
Schmidt/Dean
Cromwell/Schmidt
Sherwood-Call
Walsh
Sherwood-Call
Cromwell
Parry
Trenholme/Neuberger
Furlong
Sherwood-Call
judd/Trehan
Moreno
Glick/Hutchison
Throop
Schmidt/Gruben

The FRBSF Weekly Letter appears on an abbreviated schedule in june, July, August, and December.