by Catherine L. Mann, Peterson Institute for International Economics
and Katharina Plück
April 27, 2005
Over the last two years, the value of the dollar against the major currencies has dropped by more than 25 percent. With the dollar having depreciated so much, why haven't we seen a narrowing of the trade deficit, which in February (the latest month for which numbers are available) reached a new record of $61 billion? A dollar depreciation should bring about what economists call “expenditure switching:” As the cost of imports rises, Americans should start buying more goods made at home; in turn, our exports become less expensive for foreigners, which means foreign demand for our products should rise. This shift in exchange rates and prices should eventually correct the country's trade deficit.
But so far, Americans' appetite for imports has yet to slow. That's because, with the exception of oil, imports have not become that much more expensive. One reason is that about 30 percent of our imports come from countries whose currencies have either moved little (the Thai baht), stayed stable (the Chinese yuan), or fallen (the Mexican peso) against the dollar.
But another reason is the worldwide decline during the 1990s of what economists call "pass-through rates:" that is, the extent to which changes in the exchange rate induce changes in a country's import and export prices. A study by the economists Linda Goldberg and Jose Manuel Campa found that pass-through rates for the United States were significantly less than for other industrial countries. A 10 percent change in the dollar has generally yielded only a 2.5 percent change in American import prices within one quarter, and only a 4 percent price change after several quarters. Another study by the Federal Reserve found that pass-through was nearly zero. Indeed, in the case of the Japanese yen, even a 25 percent rise in the yen to dollar rate has generated little if any increase in the price we pay for Japanese goods.
Several factors help explain America's lower pass-through rate. Reduced inflation around the world has made prices less volatile, enabling exporters to ride out currency fluctuations without changing prices. As the United States imports more consumer goods (which have a lower pass-through rate compared with commodities), the overall pass-through rate for American imports has fallen. But perhaps most important, exporters don't want to risk losing market share in the large and competitive American market—even if that means decreasing their own profit margins to keep prices stable in the United States.
Low pass-through means that Americans have not yet lost their purchasing power abroad despite the dollar depreciation, and therefore we can continue to enjoy living beyond our means. Over the long run, though, the enormous trade imbalance is not sustainable. Low pass-through means that it will take a much bigger drop in the dollar to change prices enough to induce switching and correct the trade deficit. In fact, our colleague Ted Truman calculates that between the depreciation of the dollar and the loss in spending power, this adjustment could end up costing every American $2,350. The larger the eventual depreciation, and the longer we wait, the greater our postponed pain promises to be.
Testimony: The Fed at 100: Can Monetary Policy Close the Growth Gap and Promote a Sound Dollar? April 18, 2013
Policy Brief 12-25: Currency Manipulation, the US Economy, and the Global Economic Order December 2012
Policy Brief 12-21: How Can Trade Policy Help America Compete? October 2012
Policy Brief 12-15: Restoring Fiscal Equilibrium in the United States June 2012
Testimony: The Outlook for the Euro Crisis and Implications for the United States February 1, 2012
Testimony: A New Regime for Regulating Large, Complex Financial Institutions December 7, 2011
Op-ed: Taxing China's Assets: How to Increase US Employment Without Launching a Trade War April 25, 2011
Book: The Long-Term International Economic Position of the United States April 2009
Op-ed: New Imbalances Will Threaten Global Recovery June 10, 2010
Article: The Dollar and the Deficits: How Washington Can Prevent the Next Crisis November 2009
Speech: Rescuing and Rebuilding the US Economy: A Progress Report July 17, 2009
Book: US Pension Reform: Lessons from Other Countries February 2009
Policy Brief 09-3: A Green Recovery? Assessing US Economic Stimulus and the Prospects for International Coordination February 10, 2009
Testimony: US Foreign Economic Policy in the Global Crisis March 12, 2009
Policy Brief 07-5: American Trade Politics in 2007: Building Bipartisan Compromise May 2007
Book: American Trade Politics, 4th edition June 2005
Policy Brief 01-11: Using Sanctions to Fight Terrorism November 2001