Meet the Author

Owen F. Humpage |

Senior Economic Advisor

Owen F. Humpage

Owen Humpage is a senior economic advisor specializing in international economics in the Research Department of the Federal Reserve Bank of Cleveland. His current research focuses on the history and effectiveness of U.S. foreign-exchange-market interventions. In addition, he has investigated the Chinese renminbi peg, quantitative easing in Japan, and the sustainability of U.S. current-account deficits.

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Meet the Author

Michael Shenk |

Research Assistant

Michael Shenk

Michael Shenk was formerly a research assistant in the Research Department of the Federal Reserve Bank of Cleveland. His work focused on international topics and housing-market indicators.

12.07.07

Economic Trends

Dollar Depreciations and Inflation

Owen F. Humpage and Michael Shenk

The dollar has depreciated 24 percent on a broad trade-weighted basis since its peak in February 2002, posting its biggest losses against currencies of the major developed countries.  Since late January 2002, for example, the dollar has lost 41 percent of its value against the euro.

Dollar Exchange-Rate Movements

 
Percent change from:
01/28/2002a
08/06/2007b
Australia
−40.7
−1.4
Canada
−36.4
−3.5
Euro Area
−41.0
−5.5
Japan
−16.9
−6.7
Mexico
18.4
−3.7
United Kingdom
−30.4
−0.3

a. Peak in Major Currency Index
b. Day preceding the August FOMC meeting
Source: Bloomberg Financial Services

A dollar depreciation—all else constant—raises the price of all U.S. traded goods.  It directly increases the dollar price of U.S. imports.  Likewise, it directly lowers the foreign-currency prices of U.S. exports, but this will shift foreign demand toward our exported goods and, thereby, raise their dollar prices.  These price effects are important; they foster the adjustment in our international trade and financial accounts.

Exchange-rate-induced price changes—contrary to popular belief—are not inflationary.  Inflation is a decline in the purchasing power of money that results when the money supply rises faster than money demand.  Inflation manifests itself as a rise in all prices.  If the rate of inflation in the United States exceeds the rate of inflation in the rest of the world, the dollar will depreciate.  In fact, exchange rates may react faster than the prices of goods and services.  In this case, inflation causes a depreciation; the depreciation does not cause inflation.

Since 2006, however, the dollar has depreciated because foreign investors have become reluctant to add dollar assets to their portfolios, not because of a high U.S. inflation rate or expectations of future inflation.  The price of trade goods will rise, but as long as the Federal Reserve does not accommodate the price pressures by easing excessively, inflation will not ensue.

All this may sound like an excessive bit of economic hair splitting. To the average consumer, a price rise is a price rise.  But to a central bank the distinction is vital.  Central banks can prevent inflation; they cannot always stop relative changes in the price of traded goods.