US shocks and exchange rates

Many academics and observers emphasize that a sharp US dollar depreciation is inevitable for returning the burgeoning US current account deficit to more sustainable levels. How may such a US dollar adjustment occur, and what may it imply for global exchange rate configurations? The paper focuses on the role of US-specific economic shocks in the adjustment process, and finds that such US shocks have historically exerted a remarkably heterogeneous effect across currencies. It shows that this heterogeneity is not only due to policy choices of inflexible exchange rate regimes or to monetary policy, but to an important extent is explained by market forces, in particular the degree of financial integration – foremost in portfolio investment – though not by trade. This helps explain why it has been in particular the euro, and its predecessor currencies, as well as other European currencies that have contributed the bulk to the adjustment of the US dollar effective exchange rate over the past 25 years, while other flexible currencies have been much less responsive to US shocks.

The results suggest that currency flexibility is a necessary but not a sufficient condition for achieving a more balanced contribution across currencies to an adjustment of global exchange rate configurations. Exchange rates are responsive to foreign shocks only to the extent that market mechanisms are in place that make this transmission work, which requires in particular that countries have well-developed financial markets and are financially integrated. These findings have implications for an unwinding of global imbalances, and for monetary policy choices and financial market policies in emerging market economies.

Marcel Fratzscher