Academic journal article Economic Inquiry

Does Exchange Rate Appreciation 'Deindustrialize' the Open Economy? A Critique of U.S. Evidence

Academic journal article Economic Inquiry

Does Exchange Rate Appreciation 'Deindustrialize' the Open Economy? A Critique of U.S. Evidence

Article excerpt

DOES EXCHANGE RATE APPRECIATION 'DEINDUSTRIALIZE' THE OPEN ECONOMY? A CRITIQUE OF U.S. EVIDENCE

I. INTRODUCTION

The sharp appreciation of the dollar in the early 1980s, followed by its decline since 1985, has generated considerable interest in the output effects of exchange rate changes. Many academics, practitioners, and policymakers believe that the initial rise in the value of the dollar significantly depressed growth in the tradable goods sector of the U.S. economy, particularly in manufacturing output, and prevented the tradable goods sector from participating in the initial stages of the general U.S. economic expansion since 1982. The dollar's subsequent sharp decline, in turn, they hope will provide an independent stimulus to the nation's manufacturing sector.

According to this view, development within the U.S. economy was "two-tiered" through 1985: growth was robust in those parts of the economy not directly sensitive to international relative price changes, i.e. nontradables, such as services, construction, transport, public utilities, etc.; while growth languished in those parts of the economy producing either exportable or import-competing goods, i.e. tradable goods, such as manufactures, agriculture, forestry products, etc. Brinner [1985], Marris [1985], Cline [1986], Branson [1986], and Branson and Love [1986; 1987; 1988] provide empirical evidence linking depressed output in manufacturing industries to the strong dollar. [1] These results have been interpreted by some as evidence that the appreciation of the dollar has caused or contributed to the "deindustrialization" of the U.S. economy [e.g., Brinner, [1985]. [2]

A major shortcoming of the literature, however, is that it typically fails to distinguish between exchange rate changes that are truly exogenous and exchange rate changes that are endogenously determined with output changes by policy and other shocks. This is especially true in the "deindustrialization" debate where exchange rate shocks may be largely due to domestic macro-economic policies.

Output levels and exchange rates in a general context are both endogenous variables, and the association between them depends on the underlying disturbances and policy reactions. Depending on the underlying disturbance, an appreciation of the exchange rate may be associated with an expansion as well as contraction of aggregate output in different sectors.

For example, a disturbance emanating from the foreign exchange market that has the effect of appreciating the dollar (e.g., an exogenous shift in international investors' portfolio preferences toward dollar assets) may be considered "exogenous" in some sense, and will likely have a depressing effect on output in the tradables sector. However, a policy-induced exchange rate appreciation arising, for example, from a fiscal expansion (in a Mundell-Fleming world with high capital mobility) or a monetary contraction has ambiguous effects on aggregate and sectoral output movements. [3] While exchange rate effects reduce output in both cases, in the case of fiscal stimulus the overall net effect on output is likely to be positive, while in the case of monetary contraction, negative. Focusing on the relation between exchange rates and output alone is analogous to attributing output movements along a supply or demand curve to price changes, rather than to the underlying factors causing the curves to shift.

In this paper we take a critical look at the arguments and empirical evidence offered in support of the hypothesis that exchange rate appreciation has been an independent cause of decline in the U.S. manufacturing sector. In section II we discuss several methodological problems in estimating and interpreting the relation between output and exchange rates. In particular, we show how the overall association of exchange rate changes with outout depends on the source of the exchange rate change, i. …

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