Answer to Question #32895 in Finance for Jenny

Question

what impact might a significant currency depreciation of the US dollar have in the short run on US current account position?

Answer 1

The most obvious effects of dollar depreciation on the DP accounts are evident in the impacts on net exports, GDP, and prices.
Current-dollar GDP: When the dollar depreciates against major foreign currencies, one generally expects to see current-dollar exports
increase, as U.S. produced goods become cheaper abroad. The effect
on current-dollar imports is more ambiguous: Depreciation increases
the dollar cost of a given volume of imports, but the volume may decline to the
extent that domestic goods and services are substituted for imports in response
to the increase in the relative cost of purchases from abroad.
Assuming that the export stimulus effect and the volume effect on imports together outweigh the import-cost effect, dollar depreciation
would be expected to lead to an improvement in U.S. competitiveness, an
improvement in net exports, and a corresponding increase in GDP.
The price and quantity effects that move in opposite directions as a result of U.S. dollar depreciation are often difficult to
identify separately from movements due to other market forces. For
example, dollar depreciation against oil-producing nations’ currencies would
result in an increase in the price of imported petroleum and a likely decrease
in the quantity of petroleum imported -- the magnitude of the response would be
determined by the product’s elasticity (responsiveness to price
change). However, other developments in the economy may also affect
the demand for petroleum, such as cyclical fluctuations or changes in fuel
economy, to a degree that often cannot be readily determined. In
addition, the separate effects may be difficult to identify because the foreign
supplier may not fully pass through the costs associated with dollar
deprecation or the domestic seller of the imported product may absorb some of
these costs.
Real GDP: The effect of dollar depreciation on real GDP is less ambiguous than the effect on current-dollar
GDP. Assuming that it is possible for domestic production to
substitute for imports, dollar depreciation will lead to increases in
U.S.-based production as domestically produced goods are substituted for
imported goods. This would lead to an increase in real GDP and a
decrease in real imports. Dollar depreciation may also lead to an
increase in U.S.-based production for export, as foreigners substitute
“cheaper” U.S. goods for goods produced in their own countries. This
added production would also lead to an increase in real GDP. The
ultimate effect, however, of dollar depreciation on GDP depends on many
factors, including the extent to which other countries adjust their own
currencies in response to dollar depreciation.