On the Non-relationship Between the Dollar and the Deficit
Michael Hoffman forwarded to us an interesting short paper showing the lack of an empirical relationship between the exchange rate and the current account. He summarizes the underlying theoretical construct as two conventional claims:
(1) A cheap (depreciated) dollar causes the current account deficit to shrink.
(2) A current account deficit causes the dollar to depreciate.
My reply to him was simply the following shorter version:
Net exports are a function of real exchange rates and other factors, while real exchange rates are also an endogenous variable. It is well established that correlations between endogenous variables tell us little about the underlying structural relationships.
I wish to thank Michael for this contribution and hope our readers enjoy it.