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January 14, 1983
An Overvalued Dollar?
The current level of the dollar as measured
against many foreign currencies has led many
people to exclaim that the dollar is overvalued. What does this mean ?The value of
the dollar should adjust to the "correct" level
automatically with freely floating exchange
rates. Although many industrial countries
either intervene in the foreign exchange
market or narrowly float their currency
against a basket of currencies, they generally
float their currency freely against the dollar.
To answer the question, we must examine
the relationship between exchange rates and
prices because exchange rates convert the
purchasing power of one currency into the
purchasing power of another.
Exchange rates and prices
Imagine a world where there ere few goods
produced by several different countries. In
such a world, in the absence of transportation
costs and other barriers to trade, goods would
be priced uniformly in different markets. In
general, it makes sense that people will value
currencies for what they will buy and will
therefore tend to exchange them at rates
which roughly express their relative purchasing power. In other words, the dollar
that buys a dozen eggs should be exchanged
for foreign currency that buys the same
dozen eggs.
A major tenet of this theoretical view is the
existence of commodity arbitrage. Arbitrage
is the purchase and saleof a good for a profit.,
It is arbitrage that suggeststhat prices of
similar goods should be the same across
countries as any difference in prices would
represent a potential for profit. Since people
are motivated by profits, it stands to reason
that arbitrage will play an important role in
linking prices and exchange rates.
Evidence for this theoretical relationship
should lie in the relationships among prices
of various commodities as measured in dif-
ferent currencies. If exchange rates among
different currencies behave differently from
the prices of the traded commodities,.then
we would have reason to believe that the
relationship between individual prices and
exchange rates had been violated.
A fractured link
One type of exchange rate is a bilateral
exchange rate such as the dollar price of yen
or francs. However, if we are interested in
how the dollar performs against the yen, the
deutschemark and the pound sterling simultaneously, we would look at the U.5. rate
against a weighted basket of foreign currencies (shown in the chart). Similarly, we
can relate U.S. prices to world prices by
comparing the U.5. price index (here,
wholesale prices) to a weighted basket of
indexes of foreign prices.
Abstracting from the notion that the ratios of
international prices should equal the
exchange rate-the ultimate result of
arbitrage-we might expect that the effective
exchange rate and the ratio of foreign to U.5.
prices would move in much the same way.
The chart indicates that while the longterm movement is similar, there are many
short-term differences that give evidence
of a fractured link between exchange rates
and prices.
The shadow
As T.S. Eliot put it: "Between the idea and the
real ity ... falls the shadow." The evidence that
the common currency prices for the same
internationally traded goods are not the same
suggests that there are other considerations.
Transportation Cost. One difficulty with
examining prices lies in the cost of moving
goods across national boundaries. Researchers who have examined this issue run into the
problem that good information on transportation costs is not avai lable. However,
anyone who has shipped anything, even
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Opinions
expre::::isedin this newslE:tter do not
reflect the vie\,vs of the management
of the Federal
Bank of San Francisco,
necessarilv
or of the Board of Covernors
of fhe. Federal
Reserve System.
. through the U.S. mail, knows that the transport cost can be high.
a pound of copper from another country. But
another item, different tractors,for example,
may not be good substitutes.Apparently, the
more narrowly a product isdefined, the better
the chance of finding identical goods across
countries.
The presenceof transportation costs means
. that two prices for the samecommodity, sold
in different countries, would have to differ by
slightly more than the transportation costs to
induce arbitrageursto enter the market. If the
dollar price differenceswere lessthan transportation costs,goods arbitrage could only
result in a lossfor the arbitrageur.
StiII another reasonthat a consumer may be
willing to pay a higher price for the same
good is the uncertainty regardingthe reliability of suppliers. A customer may have
established a good working relationship with
a supplier, or commitments to certain equipment, as the result of prior purchases.
Riskpremium. Furthermore,anyone engaging in moving goods acrossnational borders
is undergoing a certain amount of risk. One
risk is that by the time the goods are moved
from one market to another, their prices may
have changed. Another is that, over the same
period, the exchangerate may have changed.
Eitherof theseeventscou Id resuIt in havi ng to
sell the goods at lessthan the price that was
originally paid plus the cost of transportation.
This risk is a common feature of any traded
commodity and it is possible, by using forward contracts, to hedge some or all of the
risk. However, formal marketsfor forward
contracts do not exist for many traded goods.
When contractsdo exist, they are frequently
of the wrong duration. This meansthat any
trader would haveto make a substantial effort
to arrangea forward contract that would
cover him for just the time the goods are in
transit.Given the amount of work involved in
such arrangements,tradersmay prefer not to
insurethemselvesfully against price and
exchange rate changes.Instead,traders may
ask higher prices for their goods as compensation for their uninsured risk.
Price differences in different marketsmay be
the result of a few sellerswhose strategies
are to maintain a certain price position re.\ative to rivals. Such behavior might exist if the
firm's long-term profit maximization would
suffer from a lossof market share.A firm may
also opt to sell at lower pricesover a period of
time to break into a market or to expand its
market share.
Evidence
Different researchers' have examined the
prices of the U.S., W. Germany, Canadaand
France and reached considerably different
conclusions. But, at leastsome oftheitdifferences can be explained by the difficulty of
taking into account someof the problems
mentioned before.
Other factors. Barrierst01rade in the form of
tariffs and quotas Canalso presentdifficulties
when looking at international prices. These
trade restrictions can causedisparities
between different setsof prices, such as
wholesale and export prices.
In order to avoid the problem of comparing
apples with oranges,the researchers
selected
products from the most disaggregated
commodity list for which prices could be
matched acrosscountries. All researchers
found evidence that certain commodities are
uniformly priced in common currency units
across countries. The resultsheld especially
well for the most homogeneouscommodities
such as coffee, cocoa and, in the earlier
example, copper. The generalconclusions
Another problem comes from whether items
can be substituted for one another. For
example, a pound of copper from one country would be virtually indistinguishable from
* Work in this area has been conducted byPeter Isard
of the Federal ReserveBoard, J.David Richardson of
the University of Wisconsin and Liliane CroucheVeyrac, Michel (raucy and jacques Melitz of Centre
d'Enseignement Superieur des Affaires andI.N.S.E.E.
2
u.s. FFECTIVE EXCHANGE RATE
E
1975"100
1 2 5
AND RELATIVE PRICES
, - - - - - - - - - - -
1975"100
---,1 25
120
120
115
115
110
-110
105
100
Relative Prices
''« ...,
......
"./
.....
-
105
. ..... .....
....
95
100
'._/
.....
95
Effective Exchange Rate
90 LW-'-LJ...LLU..L.LLU-'-LJ...Ll..L.C..L.LLU-'-L.w.JLLLJ...LLJ...L.J
90
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
are that when disparities in prices are
observed, the disparities tend to last for a
period of not more than two years.
saved. Furthermore, jobs will be destroyed in
the export industries, which for the
are
the most productive.
Generally, the resuIts indicate that commodity arbitrage does take place but not
significantly for every commodity group.
When it does take place, it is never perfect.
Concerns about protectionism resulted in the
establishment of the General Agreement on
Tariffs and Trade known as the GAI T in the
1 940s. Although GAI T has achieved substantial reductions in tariffs since its inception, trade growth has slowed in recent
years and protectionist pressures have
increased. Furthermore, trade restrictions
have resulted in tensions in the international
financial system.
u.s.
Although evidence exists that for. many internationally traded commodities the common
currency (dollar equivalent) prices are the
same or very similar across countries, there is
little to suggest that the composition of price
indexes is the same across countries. Even
in the extreme case where the price indexes
consist of items that have displayed the same
price across countries, the indexes themselves will only be the same in common
currency when the relative consumption
shares of foreign and domestic goods are
the same.
There are multiple links between international trade and financial markets. One is that
an exporting country must keep an open
market for imports so that foreign debtors can
earn the foreign exchange needed to service
their debts. Another is that domestic firms are
increasingly organized on a global scale.
Since the majority of the banking system's
assets are loans to domestic firms, the quality
of those assets must depend on their profitability which, in turn, depends on the stability
of international business.
Protectionism
What happens when the exchange rate gets
"out of I ine"? Since the exchange rate is such
an important price, it affects almost all
aspects of the economy. I f the U.s. dollar
were "out of line", say higher than what we
might expect it to be (in the sense that it buys
more of a foreign currency), then the level of
foreign prices wou Id appear lower. American
goods would become expensive relative to
foreign goods and both Americans and
foreigners wou Id buy fewer American goods
and more foreign goods. The situation can, at
times, lead to calls for protectionist measures
for American industries.
Conclusion
Although there appears to be no "good"
measure for a long-term exchange rate, the
evidence suggests that prices and exchange
rates cannot be divorced from one another.
Furthermore, perceptions that the exchange
rate is "out of line" -based on whatever
measure-carry with them the possibility
that industries will feel threatened and ask for
protection. Granting protection, however,
has far-reaching consequences and may
produce more devastating results than
the originally perceived evil-an overvalued dollar.
Any government is concerned with the
national expansion of its export and import
industries which depend directly on one
another. Limiting imports by tariffs or quotas
also limits exports because it reduces the
purchasing power of customers and raises the
costs of domestic producers dependent on
foreign materials, making them less competitive. If, to save jobs, many countries simultaneously follow a program of restricting
imports, more jobs may be destroyed than
Elizabeth Christensen
3
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BANKINGDATA-TWELFTH
FEDERAL
RESERVE
DISTRICT
(Dollaramounts millions)
in
Selected
Assets
andliabilmes
Large
Commercial
Banks
Loans
(gross,
adjusted) investments*
and
loans (gross,
adjusted)
-total#
Commercial industrial
and
Real
estate
Loans individuals
to
Securities
loans
U.s.Treasury
securities*
Othersecurities'"
Demand
deposits total# .
Demand
deposits adjusted
Savings
deposits total
Timedeposits total#
Individuals,
part.& corp.
(Large
negotiable
CD's)
WeeklyAverages
of Daily Figures
MemberBankReserve
Position
Excess
Reserves )/Oeficiency
(+
(-)
Borrowings
Netfreereserves )/Netborrowed(
(+
-)
Amount
Outstanding
Change
from
12/29/82
12/22/82
668
579
373
- 13
172
91
10
99
1,075
888
2,874
-1,987
-2,020
- 818
163,668
143,376
45,826
57,331
24,005
2,827
6,996
13,296
43,144
29,684
44,376
88,242
78,303
30,503
Weekended
12/29/82
115
,9
106
Change
from
yearago
Dollar
Percent
7,061
7,976
4,416
1,436
183
800
1,153
2.068
750
21
14,201
1,735
- 2,538
- 5,908
Weekended
12/22/82
134
25
109
4.5
5.9
10.7
2.6
0.8
39.5
19.7
- 13.5
- 1.7
0.0
47.1
1.9
- 3.1
- 16.2
Comparable
year-ago
periocl
-
352
14
338
* Excludes
trading
account
secuntles.
# Includes
items shown
not
separately.
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may
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