Xavier Gabaix on a strong vs. weak dollar

He emails to me:

Hi Tyler, Alex

Tyler asks Is a strong dollar better than a weak dollar? and says “Yes, for Americans though not for the world as a whole.  For the relevant thought experiment, assume an exogenous shift in noise trading boosts the value of the dollar.  That increases the wealth of individuals and institutions that are long dollars, and presumably this is the case for this country overall.”

Actually, I think that the baseline economic answer is Neither : the optimal level is just the equilibrium frictionless real business cycle level — if the dollar is above or below it, the US is worse off (and so is the rest of the world).

Why? Matteo Maggiori and I have a model to analyze such things (“International Liquidity and Exchange Rate Dynamics”, QJE 2015) – a full-fledged GE model  that allows to study in particular the effects of those noise trader shocks.
Short version: a strong dollar appreciation now helps the US now (as Tyler rightly says), but will force a depreciated dollar later (as this GE intertemporal model works out), which will hurt the US later. Summing over all periods, it’s a small (2nd order) negative.

Long version (see section II.D and III.B of the paper). Suppose there are 2 periods. At time 0, Tyler is right – the US is better off that period. However, that creates a trade deficit, which increases US indebtedness, and that will create a lower dollar in the future, and will hurt the US (as Tyler would rightly have said). E.g. if the equilibrium dollar yen rate is 100, and if the dollar is stronger at 105 at 0 because of a demand shock, then at period 2 it will need to be 95 (the logic also works with more than 2 periods). All in all, it’s a first order wash, and the loss comes from the 2nd order distortion terms (worked out in full detail in Proposition 8 of the NBER WP version). Likewise, a weak dollar now would hurt the US now, help the US later – again with a small negative overall.

A caveat: if the US is in a recession with high unemployment, a weak dollar is strictly better (for the US and the world), as it alleviates unemployment and increases total production.

Policy conclusion: don’t intervene, unless you have a very strong reason to think your currency is appreciated (or depreciated) – then, reverse that via FX interventions.
I hope that helps.
Continued thanks for the great blog!

TC: My theory of exchange rates is “less intertemporal” than that, but a fantastic answer in any case.  Read also Ryan Avent on all of this.


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