Dollar Depreciation
Calculating what value of the dollar might yield a sustainable trajectory for the current account is a difficult task, since the two are endogenous; that is, the sustainable value of the dollar depends on the sustainable value of the current account deficit. Moreover, both of these have important effects on growth and trade in the rest of the world. Wren-Lewis and Driver (1998) offer one set of calculations for the dollar that depend in turn on calculations for the current account from a detailed global model.
Wren-Lewis and Driver calculate a fundamental equilibrium exchange rate (FEER) value of the dollar for 2006 of about 95 yen/dollar and about 1.3 dollars/euro. Compared with the exchange rates that prevailed at the beginning of 1999, this suggests that the dollar would need to depreciate some 25 percent against the yen and 10 percent against the euro. On the basis of broader trade weights, 25 percent is a good ballpark figure for how much the dollar would have to depreciate to reach its fundamental equilibrium exchange rate. Suppose this depreciation took place immediately, and the dollar stayed at this lower level for the duration of the scenario. The effects of this depreciation over the next few years would be dramatic; indeed, the simple framework overemphasizes the speed with which the current account would respond. The key point, however, is that over the longer term, dollar depreciation would only postpone the sustainability problem, not eliminate it.
Suppose, then, that the dollar did depreciate some 25 percent. The current account deficit would be cut in half, with the effect on the trade deficit even larger. The CA/GDP ratio would narrow to less than -2.0 percent in the next two or three years.............
