The Federal Reserve Bank of New York today released Why a Dollar Depreciation May Not Close the U.S. Trade Deficit, the latest article in its series Current Issues in Economics and Finance.
Responding to the conventional argument that a dollar depreciation can significantly narrow the U.S. trade deficit, authors Linda Goldberg and Eleanor Wiske Dillon contend that a weaker dollar is unlikely to alter consumption patterns sufficiently to eliminate the gap between U.S. exports and imports.
In theory, the authors explain, a dollar depreciation should raise the cost of foreign goods in the U.S. market, prompting American consumers to reduce their demand for imports. At the same time, a weaker dollar should boost foreign consumers' purchases of U.S. goods by making those goods more affordable abroad.
While acknowledging that the depreciation will push down the prices of U.S. exports, the authors point to three factors that will keep U.S. import prices from rising enough to curtail demand for foreign goods significantly. The first of these factors is the near-exclusive use of the dollar in invoicing U.S. trade. Because 93 percent of U.S. imports are invoiced in dollars, the price of most imports remains fixed for a period when the dollar depreciates. Although foreign exporters are free to adjust their prices over time, a second factor—the desire to remain competitive in the large U.S. market—may lead exporters to forgo substantial increases in their prices in the longer run.
Finally, the high marketing and distribution costs added to imports once they enter the United States may lower the portion of the final price that responds to a dollar depreciation. This third factor, the authors note, "has the effect of further insulating U.S. import prices from exchange rate movements."
The unresponsiveness of U.S. import prices to a dollar depreciation leads Goldberg and Dillon to conclude that U.S. imports will play "only a minor role" in the easing of the U.S. trade deficit via the dollar effects channel. "Any substantial trade balance adjustment achieved through exchange rate changes," the authors observe, "must come instead from a reduction in export prices"—that is, from a reduction in the foreign currency prices that consumers abroad pay for U.S. goods.
The authors' quantitative analysis shows that export prices do in fact react more strongly than import prices to a dollar depreciation. As a result, the quantity of U.S. goods exported to other countries will rise with a weaker dollar. Nevertheless, Goldberg and Dillon caution that without a decline in the consumption of imports, the growth in exports required to close the U.S. trade deficit through a dollar depreciation will be immense.