OK, I make a comment over at Dan Drezner’s blog in line with my Sunday blog here and the “crowd” goes nuts. You see – they think I don’t realize that the dollar has devalued. a of the real exchange rate does have our real exchange rate down to 92.22 (1973 = 100) from 116.77 in February 2002 (what the crowd is focused on, I guess). I could point out that this index was only 107.73 when Bush took office and was up from 96.33 as of October 1999 – and then appeal to some alleged lag between changes in real exchange rates and the impact on export demand. Then again – the crowd has argued that I’ve just admitted that the dollar was strong during the late Clinton years too. I might counter that the late Clinton years were a period of strong investment versus modest national savings whereas we now have modest investment and very little savings.
But I’ve done some Mundell modeling on the back of an envelope and this modeling makes a more fundamental point if you permit me to do an exercise that pretends we stay at the same level of income relative to full employment ala either Mundell perfect capital mobility of well-timed monetary policy (OK, it’s a really simple model I’m putting forth). The model assumes flexible exchange rates and two exogenous shocks to an economy with income equal to $10 trillion:
a rise in domestic demand from fiscal stimulus equal to 3% of income ($300 billion); and
a fall in export demand (from weakening economies abroad, foreign trade protection, or any other foreign shock) equal to 4% of income ($400 billion).
This model predicts that the second shock will lead to a dollar devaluation with no impact on the domestic economy as well as no net effect on net exports as the currency devaluation offsets the foreign shock.
It also predicts that the first shock will appreciate the dollar enough to crowd out net exports by $300 billion. Is this not how White House economists tried to argue that fiscal stimulus does not raise interest rates?
On net, the impact on the exchange rate would be for a net depreciation equal to the ratio of $100 billion and the parameter from exchange rate changes to net export demand. So a Mundell model could explain recent macroeconomic history and yet challenge Dan Drezner’s notion that this has little to do with the Bush Administration.
(BTW – the “crowd” meant those who replied to his blog. The folks here were a bit more gentle to my musings).