The Strong Dollar Debate, Yet Again

Dollars, Currency, Money, Us Dollars, Franklin

(Somewhat repetitive of a 2007 post…)

Steven Englander of Standard Charter writes several weeks ago (not online):

“From the Treasury’s perspective, the purpose of a strong dollar policy is less a strong dollar itself than to encourage foreigners to lend to the US on favourable terms even when the dollar is under pressure. The success of a strong dollar policy is reflected in the absence of USD risk premium on US assets when the USD is weak. In fact, the preferred asset market outcome is probably for the US to gain an export advantage via a weak dollar without paying a price on the financing side. But to be clear, the negative correlation between the USD and US yields over a period of decades suggests that neither an overtly strong nor an overtly weak USD policy affects borrowing costs significantly”

Is there a link between the interest rate and the currency’s value, in theory or in practice? At this point, it’s important to distinguish between the level of the currency’s value and the rate of change in the currency’s value.

The overshooting model of the exchange rate due to Dornbusch and Frankel says the real interest differential determines the value of the currency (higher relative real interest rates induce a stronger currency), while interest rate parity (a building block of the overshooting model) indicates currency depreciation must equal nominal interest differential, ignoring risk premia. Even if real interest rates only explain a small proportion of exchange rate levels, they are about the only one that works empirically.

Regarding the concern about higher US long term interest rates (short rates discussed here), the question is whether longer term interest rates — which are more relevant to financing costs of the Federal government — do indeed hold to uncovered interest parity. Actually, there’s a second question if the answer to the first is “yes” – that is whether it’s US interest rates or foreign interest rates that move in response to expected depreciation. (On this, I’m not aware of much research, aside from Bruneau and Jondeau (1998)Chinn and Frankel (2006) find a role for US government bond yields on for foreign government bond yields, but not vice versa).

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