As the U.S. trade deficit reached unprecedented levels in the first half of the 1980s, different explanations emerged for the cause and persistence of the deficit. The traditional elasticities approach ascribed the widening of the deficit to the appreciation of the dollar and differences in the growth rates between the U.S. and its trading partners. Bryant and Holtman (1987), Helkie and Hooper (1987), and Krugman and Baldwin (1987), for example, suggest that the rise in the value of the dollar accounted for most of the deterioration in the trade balance.
An important challenge to the conventional analysis of trade deficits was mounted by Bergsten and Cline (1985), Mundell (1987), and Mackinnon and Ohno (1986). They relate the trade balance to the difference between national income and national expenditure or, equivalently, to the difference between saving and investment. This approach suggests the irrelevance of exchange rates as a factor in determining the current account equilibrium. The results of these studies, however, rest on the strong assumption that changes in nominal exchange rates do not have a lasting influence on relative prices.
Feldstein (1987), Hutchinson and Piggot (1984), and Laney (1984) suggest that the primary reason for the deteriorating trade balance is the U.S. budget deficit. The persistence of large budget deficits is thought to have caused the long term real interest rate differential and an appreciation of the dollar. The appreciation of the dollar dramatically increased the price of American products relative to foreign products leading to a decline in the volume of U.S. exports and an increase in imports.
An alternative explanation rooted in the modern theory of trade balance determination (Greenwood, 1984; Razin, 1984; and Hill, 1990) suggests that the main reason for the external trade imbalances is intertemporal shocks that shift the time distribution of consumption and production. It is argued that these disturbances affect both the exchange rate and trade balance. One implication of the modern theory is that the conventional theory may exaggerate the importance of exchange rates as factors initiating change in the size of the trade balance. According to this theory, the real exchange rate initially changes to accommodate the existing imbalances in trade. This in turn induces subsequent changes in the trade balance. Thus, as Hill (1990) argues, the relationship between the exchange rate and the trade balance may be bidirectional.
The persistence of trade deficits despite the sharp depreciation of the dollar in the second half of the 1980s posed serious questions to the conventional exchange rate explanation of trade balance. Helkie and Hooper (1987), Krugman and Baldwin (1987), and Rosenweig and Koch (1988) address the persistence of the deficit and conclude that it reflects, for the most part, normal lags in the adjustment to a depreciation of the dollar that followed a long period of appreciation.
Others suggest that the current empirical dollar indices are flawed in their construction and hence have overstated the depreciation of the dollar. They argue that while the dollar had depreciated sharply against the currencies of Japan and western Europe, the currencies of many LDCs had depreciated against the dollar. To address these perceived shortcomings, numerous new dollar indices have been proposed. For example, Rosensweig (1986), Cox (1987), and Harvey and Strauss (1987) have constructed alternative indices to measure the foreign exchange value of the dollar.
The wide disparity of views on the relationship between exchange rate changes and trade balance points to the need for further study of the issue. Most …