Friday, March 15, 2013

The dollar has NOT depreciated since the 1970s?

Mike Norman had an intriguing graph a while ago (see here) showing that if one uses the broad, rather than the major currencies, index for the US trade weighted exchange rate, then the dollar did not depreciate (which I prefer to go down, since if you define the exchange rate as the domestic price of foreign currency, as most countries do, up is actually a depreciation). I decided to explore the issue. I reproduce the graph below, putting both indexes together.
Note that these are nominal exchange rates. The broad index, as noted by Mike, actually only depreciates in the 2000s, and overall has not depreciated.

The difference between the two rates are the countries that are included in the respective indexes. In the broad index there are 26 countries (one is not a country really, the Euro-area), while the major currencies index includes only 7 currencies, which are traded widely outside of their home country, namely: the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. The broad index includes developing countries like Argentina, Brazil, Chile, China, India, Mexico, Russia, South Korea and Venezuela. An explanation of how the indexes are built can be found here. The weights used now for calculating the indexes are here.

Note that rates of inflation in developing countries, particularly in the 1970s and 1980s, when the two exchange rates diverge widely, were considerably higher than the rates of inflation (which were at historical high levels, but much lower) in developed countries and the US. So what happens when we look at the real indexes, broad and major currencies?
As it can be seen, the real indexes are quite similar, and by all measures the dollar has depreciated in real terms from the early 1970s, with two big swings associated to the Reagan and Clinton (asset bubble driven) booms. The point is that in countries with higher inflation than the US depreciated their currencies in nominal terms significantly (in part that explains their higher inflation rates), and in nominal terms the US currency appreciated, but once inflation is taken into consideration the index looks very much like the major currencies one, with an overall depreciation of about 20% or so in real terms.

Note that this does NOT threaten the international position of the dollar, and the US does not need to depreciate its currency to solve a current account problem. And in fact if you look at the last crisis, which started in the US, you still had an appreciation associated to a run to the dollar. For more on that see this paper.

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