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World Economic Problems For the Summit:
Coordination, Debt, and the Exchange Rate System

Dr. Rudiger Dornbusch

Bissell Paper Number Six
Centre for International Studies, University of Toronto
May, 1988

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3. HOW MUCH OF A FURTHER DOLLAR DECLINE?

Most econometric estimates of U.S. trade flows suggest that considerable further depreciation is required to cut the external balance to near zero. Just how much further depreciation depends on what is believed to be a sustainable level of the deficit and what is assumed about relative growth rates of spending here and abroad.

My own estimate is that from the level reached in December 1987, a further 15-20 percent real depreciation of the trade-weighted real dollar exchange rate needs to occur since many currencies are kept in line with the dollar and inflation differentials are small, this implies major further depreciation of the nominal dollar/DM and dollar/Yen rates. Furthermore, as discussed below, since there is considerable downward flexibility in prices at least in Japan, the nominal exchange rate of the Yen may have to go very far before the required real adjustment has occurred. A rate of 100 Yen/$ by late 1988 is not at all excluded.

An alternative to dollar depreciation is, of course, a sharp acceleration of foreign relative spending which would eliminate the US deficit. Japan is currently experiencing a major increase in the growth of domestic spending, but that is not the case for Europe. (See Table 2)

Table 2: Growth in the U.S and Abroad
(percent of per year)
 1984-8619871988*1989*
U.S.
Real GDP
Real Demand
 
3.9
5.1
 
2.8
2.0
 
2.5
1.0
 
1.8
1.0
Japan
Real GDP
Real Demand
 
4.0
3.9
 
3.5
4.3
 
3.0
4.0
 
3.0
3.3
Europe
Real GDP
Real Demand
 
2.6
2.6
 
2.3
3.3
 
1.8
2.5
 
1.5
2.0
*forecast
Source: OECD Economic Outlook, December 1987

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