How does the exchange rate affect the U.S. trade deficit?
In my last blog post, I studied the anatomy of the U.S. trade deficit. Now I am analyzing the importance of the exchange rate of the dollar for this deficit. To limit the scope, I will restrict myself to trade relations between the United States and the European Union (EU). Hence the development of the value of the euro against the U.S. dollar plays a decisive role.
Depreciation of the euro
Looking at the exchange rate between the U.S. dollar and the euro since 2007 (the last year before the Lehman bankruptcy), we see a general depreciation of the euro against the dollar, at least since 2008 (see figure 1). The mirror image of the depreciation of the euro is an appreciation of the dollar:
- The euro reached its highest value during this period in April, May and June 2008, when one euro cost around $1.60.
- The euro reached its lowest value in February and March 2017 at around $1.05.
- Currently (June 2018) one euro costs about $1.15.
Exchange rate changes and trade flows
The depreciation of the euro against the dollar improves Europeans’ export opportunities. Here is a simple example: Let us assume that a European company produces cars at a price of €10,000. With the exchange rate developments outlined above, this car costs $16,000 in spring 2008. In February and March 2017, the same car had a price of only $10,500. A price drop of $5,500 (or 35 percent) results in greater American demand for European cars. Hence European exports to the U.S. increase.
For the U.S. economy, this exchange rate development results in a decline in sales in Europe. The appreciation of the dollar raises the price of U.S. products in Europe. As a result, U.S. exports to Europe are declining.
Dollar appreciation and U.S. trade balance
The described interrelationship between the exchange rate development of the dollar (respectively the euro) and the U.S. trade balance can be read in the official statistics. Just as in the last blog post, the following data on the U.S. trade balance (exports and imports of goods and services) are taken from the Bureau of Economic Analysis statistics (last update: 6 June 2018):
- From the beginning of 2007 to summer 2008, the price of one euro rose from $1.30 per euro to $1.60 per euro. This appreciation of the euro reduced the bilateral trade deficit of the U.S. with the EU from almost $80 billion in 2007 (and even $105 billion in 2006) to $58.5 billion in 2008 and $23.4 billion in 2009 (see Figure 2).
- The euro then lost value against the dollar. In April 2015, the value of one euro was around $1.05. The resulting appreciation of the dollar led to an increase in the U.S. trade deficit with the EU to $102 billion in 2015.
- Thereafter, the dollar-euro exchange rate remained more of less constant for the next two years. The same applies to the bilateral trade balance.
What dollar development can we expect?
Exchange rate developments are affected by many factors. They are therefore difficult to predict. However, tendency predictions are possible. Two closely related economic factors play an important role: economic growth and interest rate developments.
- When a country’s economy is growing strongly, companies generate high sales and, as a rule, high profits. It is now more attractive for international investors to invest their money in this country in order to benefit from the economic upturn. These investments usually have to be paid in the currency of the growing economy. There is therefore a high demand for the currency of this country, i.e. an appreciation.
- High economic growth goes hand in hand with high consumer demand for goods and services. The high demand leads to rising prices. To avoid a rise in inflation, the country’s central bank must intervene. It will raise the key interest rate in order to reduce the money supply and reduce inflationary pressure. Higher interest rates in turn are an incentive for international investors to invest their money in this country. Demand for the currency of this fast-growing country is rising. The result is a further appreciation of this country’s currency.
So in order to make a prediction about the future exchange rate of the dollar, we need to look at the growth forecasts for the U.S., the European Union and the euro zone. The International Monetary Fund (IMF) made forecasts in its World Economic Outlook of April 2018. As shown in Figure 3, the U.S. real gross domestic product (GDP) is expected to grow faster than the real GDP of the European Union or the euro zone, at least in 2018 and 2019.
This means that the U.S. dollar is expected to appreciate slightly in 2018 and 2019. For the balance of trade between the U.S. and the European Union, this implies that the American trade deficit will continue to increase.
What impact will US punitive tariffs have on the exchange rate?
As already shown U.S. import duties lead to a price increase in the U.S. The central bank of the United States, the Federal Reserve System, will respond to the inflationary pressure and increase interest rates. However, this increases the incentive for international investors to invest their money in the U.S. Hence, there will be a stronger demand for dollars, which will result in an appreciation of the dollar. The consequence is a decline in U.S. exports. The trade deficit of the American economy will thus increase.
In addition, the appreciation of the dollar is making European products in the U.S. cheaper. As a result, U.S. imports from Europe are increasing. The American trade deficit will therefore become even larger.
A strong U.S. dollar is one major reason for the current trade deficit in the U.S. As long as the American economy grows and the dollar has a high value against other currencies, this deficit will remain. Punitive tariffs will hardly be able to reduce the U.S. trade deficit. If the U.S. wants to reduce its import surplus, it will have to curb its credit-financed consumption in particular.