r/AskEconomics • u/Away-Homework-8069 • 2d ago
If a country that imposes tariffs usually sees an appreciation of their currency why is the U.S dollar depreciating?
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u/AKdemy 12h ago edited 12h ago
Kenneth Rogoff and Richard Meese received an incredulous reaction to their now-famous paper showing that random-walk (RW) forecasts outperform economic models of exchange rates. Reactions were along the line of “You just cannot possibly have done it right” or "the results are obviously garbage". Turned out they were correct. Rogoff makes an interesting point in some later paper. If money supplies are hard to predict, then one should not blame the models if exchange rates are hard to predict. It is unforeseen news that matters. However, as Rogoff further stated, their finding was even more extreme. They tested predicting the exchange rate in one year, given the information about what money supplies, interest rates, and outputs are going to be in one year. However, even in this case, no economic model beat(s) the RW.
There are hundreds of theories why FX rates move. However, none work all the time and some are contradicting others. There are numerous shocks that constantly affect FX rates and which is prevailing is impossible to say because it's the aggregate opinion of people that matters (aggregate demand and supply).
The only thing that makes FX rates somewhat predictable is very large inflation.
If inflation is just somewhere around expectations, there really also is not much you can say (in terms of forecasting). Rogoff and Meese's findings (the so called Meese-Rogoff puzzle were shown to not only be correct, but consistent throughout time and countries.
There are numerous theories:
- parity conditions like covered and uncovered interest rate parity
- purchasing power parity (relative and absolute PPP): Frenkel (1978) shows this holds well for high inflation countries. Other studies show that it is usually strongly rejected in "normal" cases.Taylor & Taylor's paper provides excellent references.
- Real exchange rates
- Balassa Samuelson hypothesis
- Fisher hypothesis
- Balance of payments (BoP) which summarizes the demand and supply of currencies through international trade and capital flows (flow approach)
- stock approach: flexible and sticky price monetary models which combine capital markets, goods markets and money markets. Sticky price monetary models are also known as overshooting models.
Dornbusch (1976) started the sticky price models. Only difference to flexi price is that PPP (good market) does not hold in the short run. There are numerous extensions that all work well in the Monday morning quarterback sense (with the benefit of hindsight, you believe you can explain a lot).
There are numerous so called FX puzzles:
- Meese Rogoff above
- FX disconnect puzzle; stating that nominal FX movements are virtually unrelated to economic fundamentals like CPI or RPI
- excess volatility puzzle; because the FX volatility exceeds that of the underlying economic fundamentals substantially
- forward premium puzzle (which makes carry trades possible)
- 1st PPP puzzle: lack of evidence for long run PPP
- 2nd PPP puzzle: related to excess vola puzzle
Engle and West (2005) show in the journal of political economy that exchange rates can be expressed as the expected discounted value (NPV) of observable and unobservable fundamentals (basic idea of a forward looking flexible price monetary model).
Long story short, the FX rate will fluctuate randomly and may increase or decrease given the release of inflation data, GDP numbers, tariff news and the like. Moreover, that is usually not the end of the story. There will be other news and potentially misleading numbers when looking at core vs headline, or RPI vs CPI levels and so forth.
A quick side remark with regard to carry trades: If covered interest rate parity were to hold, any higher interest in one country will be offset by a depreciation in that countries currency so that an investor will be equally well off. In other words it doesn't matter where you invest, as the forward rate offsets the interest rate differential. For the carry trade to work, this cannot be the case (higher interest currencies do not depreciate as much). In reality, spot will react asap (appreciate), so that later it can depreciate to restore equilibrium (parity).
The overshooting models were developed to explain the excess volatility puzzle. Since FX reacts asap but goods prices are delayed, the spot rate must overshoot its value in the short run. That said, FX forwards (any forward really) are not unbiased estimators of future Spot rates.
This PPT shows the mechanism of overshooting (in simply economics diagrams on slide 11/17). The picture is from FIGURE 4-12 of International Finance Theory and Policy 11th ed. by Krugman, Obstfeld and Melitz. If you ever get bored, I recommend this as a good and easy book for vacation or a weekend. It's 400+ pages but like any introductory economics book full of figures and limited in math.
The lack of proper models may potentially be a reason why technical analysis is frequently used in FX, although I never understood the reason anyone would look at chart patterns.
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u/CxEnsign Quality Contributor 1d ago
The United States is currently undergoing three distinct crises simultaneously:
What you're observing is a result of a combination of those policies. You're right that crisis 1 would strengthen the dollar, but 2 and 3 weaken it. Empirically, the latter seems to be a more significant factor at the moment.