Weak Dollar

By Spencer

In 1971 when Nixon imposed price controls he did not do it because the on-going domestic inflation rate was about to accelerate. Rather, he imposed price controls because he expected the planned dollar devaluation to be very inflationary.

But his actions just reflected the economic consensus that the dollar devaluation would be highly inflationary. But since 1971 we have learned that this basic attitude — based largely on the old two commodity two country model widely taught in introductory economic courses — just did not reflect the reality of a 180 country and infinite product world. What we have learned in the 31 years since the Nixon devaluation is that business is much more flexible and adaptable than this simple model implies. As a consequence the inflationary impact of a weak dollar is much smaller than generally believed.

Actually, if you look at the historic data the correlation between the change in the dollar and the change in inflation is plus 0.2. That is not very powerful, but even more important it is the wrong sign. The positive correlation implies that a weak dollar is deflationary and we were all taught in introductory economics that this can not be true.

Moreover, if you look at the historic record the dollar has fallen in 23 of the last 31 years since
Nixon first devalued the dollar in 1971, or almost two-thirds of the time. This implies that a weak dollar is more the norm for the US than a strong dollar.

Another example of how the economy is much more flexible than theory implies is to look at what happened when the Chinese Yuan appreciated about 21% from 2004 to 2007. As the chart shows the price index of US imports from China rose after a lag from around 97 (2003=100) to almost 104 in 2007, a gain of about 7%, or one third of the Yuan appreciation. Moreover, after the Yuan quit appreciating the price of US imports from China fell back to about 100, so the net result of the 21% change in the $/yuan exchange rate was about a net 3% rise in the price of US imports from China. Note that the two scales in the chart are on a 3 to 1 ratio.

The other argument around is that a weak dollar cause commodity inflation, and as evidence the tight correlation between the dollar and oil since around 2000 is shown. However, from the 1970s through the 1990s the correlation between the dollar and oil was positive. Around 1980 one of the CFA exam economic questions was how did higher oil prices impact the dollar. The correct answer was that since oil was denominated in dollars higher oil prices meant that Europeans, the Japanese and others had to buy more dollars to buy the same amount of oil.
So higher oil prices caused the dollar to appreciate. I guess this is just another example of the old line that economist do not change their exam questions, they just change the answers.

Now it looks like a weak dollar means that the price of oil in Euros and/or Yen, etc, does not rise as much so that the negative price elasticity of demand from higher oil prices is dampened and a weak dollar causes oil and/or commodity prices to rise more than they would with a flat dollar.