International Investors, the U.S. Current Account, and the Dollar

Two main forces underlie the large U.S. current account deficits of the past decade. The first is an increase in U.S. demand for foreign goods, partly due to relatively faster U.S. growth and partly to shifts in demand away from U.S. goods toward foreign goods. The second is an increase in foreign demand for U.S. assets, starting with high foreign private demand for U.S. equities in the second half of the 1990s, and later shifting to foreign private and then central bank demand for U.S. bonds in the 2000s. Both forces have contributed to steadily increasing current account deficits since the mid-1990s, accompanied by a real dollar appreciation until late 2001 and a real depreciation since. The depreciation accelerated in late 2004, raising the issues of whether and how much more is to come and, if so, against which currencies: the euro, the yen, or the Chinese renminbi.

We address these issues by developing a simple model of exchange rate and current account determination, which we then use to interpret the recent behavior of the U.S. current account and the dollar and explore what might happen in alternative future scenarios. The model's central assumption is that there is imperfect substitutability not only between U.S. and foreign goods, but also between U.S. and foreign assets. This allows us to discuss the effects not only of shifts in the relative demand for goods, but also of shifts in the relative demand for assets. We show that increases in U.S. demand for foreign goods lead to an initial real dollar depreciation, followed by further, more gradual depreciation over time. Increases in foreign demand for U.S. assets lead instead to an initial appreciation, followed by depreciation over time, to a level lower than before the shift.

The model provides a natural interpretation of the recent behavior of the U.S. current account and the dollar exchange rate. The initial net effect of the shifts in U.S. demand for foreign goods and in foreign demand for U.S. assets was a dollar appreciation. Both shifts, however, imply an eventual depreciation. The United States appears to have entered this depreciation phase.

How much depreciation is to come, and at what rate, depends on how far the process has come and on future shifts in the demand for goods and the demand for assets. This raises two main issues. First, can one expect the deficit to largely reverse itself without changes in the exchange rate? If it does, the needed depreciation will obviously be smaller. Second, can one expect foreign demand for U.S. assets to continue to increase? If it does, the depreciation will be delayed, although it will still have to come eventually. Although there is substantial uncertainty about the answers, we conclude that neither scenario is likely. This leads us to anticipate, in the absence of surprises, more dollar depreciation to come at a slow but steady rate.

Surprises will, however, take place; only their sign is unknown. We again use the model as a guide to discuss a number of alternative scenarios, from the abandonment of the renminbi's peg against the dollar, to changes in the composition of reserves held by Asian central banks, to changes in U.S. interest rates.

This leads us to the last part of the paper, where we ask how much of the dollar's future depreciation is likely to take place against the euro, and how much against Asian currencies. We extend our model to allow for four "countries": the United States, the euro area, Japan, and China. We conclude that, again absent surprises, the path of adjustment is likely to be associated primarily with an appreciation of the Asian currencies, but also with a further appreciation of the euro against the dollar.

A Model of the Exchange Rate and the Current Account

Much of economists' intuition about joint movements in the exchange rate and the current account is based on the assumption of perfect substitutability between domestic...