Interest rates, exchange rates and international adjustment

Michael Dooley, David Folkerts-Landau and Peter Garber

Conference Series ; [Proceedings], 2006, vol. 51

Abstract: It is generally accepted that adjustment must occur to ultimately remove the imbalances from the international monetary system. The dispute has been between a view that the system will end abruptly and soon and a view that is will last for years more with a smooth adjustment in interest rates and exchange rates. Here, we presume that the basic system that has dominated at least the last five years will continue for years more, while converging to a sustainable equilibrium. With this system as a background, we examine the behavior of interest rates and exchange rates following a variety of shocks to the international monetary system. Our analysis suggests that real interest rates in the US and Europe will remain low relative to historical cyclical experience for an extended period but converge slowly toward normal levels. During this adjustment interval, the US will continue to absorb a disproportionate share of world savings. Moreover, after a substantial initial appreciation, the floating currencies remain constant relative to the dollar in the undisturbed background system. An improvement in the investment climate in Europe during the adjustment period would generate an immediate depreciation of the euro relative to the dollar. In real terms, the dollar and the floating currencies will eventually have to depreciate relative to the managed currencies. But most of the adjustment in the US trade account will come as US absorption responds to increases in real interest rates.

Keywords: Interest rates; Foreign exchange rates; Balance of trade; International trade (search for similar items in EconPapers)
Date: 2006
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Working Paper: Interest Rates, Exchange Rates and International Adjustment (2005)
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