Delving Into How the Greenback Turns
by Travis Pantin
Wed, 2 Jan 2008 at 12:29 PM
What determines the value of the dollar?
On the Econbrowser blog, a University of Wisconsin professor of economics, Menzie Chinn, outlines the different methods available for assessing what forces are pushing the dollar in different directions, and where its optimal price lies.
Mr. Chinn points his readers to a working paper by a senior adviser for the International Monetary Fund, Peter Isard, which provides a concise survey of the different methods that economists use to determine currency exchange rates.
According to Mr. Isard, economists have quite a few ways to price currencies against each other. However, because each methodology involves a different set of assumptions and simplifications, they often produce different results.
Mr. Chinn writes about Mr. Isard's paper: "What is particularly useful about this survey is that it reminds us that there is a great degree of uncertainty surrounding not only the parameters of interest, but even the models that might be most useful in discerning the future path of the dollar." One of the models implies that the dollar's exchange rate in 2006 was fairly close to equilibrium, while others suggest substantial overvaluation.
In the end, Mr. Chinn offers his own outlook: "While several observers point to a bottoming out of the dollar in 2008, for either cyclical or monetary policy-based reasons, I think we need to take our cue from the current account balance (and income components thereof). For me, that seems to signal continued decline."
ANOTHER DOLLAR INDICATOR
A report published by the International Monetary Fund has some analysts worrying that the dollar has been dethroned as a global reserve currency. The greenback's share of global reserve holdings fell to a record low during the fourth quarter of 2007, according to the report.
However, a fellow at the Council on Foreign Relations, Brad Setser, writes on the RGE Monitor blog that the change is not something that should cause much worry.
"I would caution against reading too much into the fall in the dollar's share of global reserves in the latest IMF COFER data release," he writes. "Most of the fall in q3 is explained by the rise in the dollar value of the world's existing holdings of euros and pounds."
The amount of global dollar reserves has been shrinking not because foreign countries are selling their greenbacks in the expectation that America's economy is heading into a recession, Mr. Setser writes. Rather, the change is a result of the dollar's recent decline in value against the pound and the euro, which has caused the percentage of global reserve wealth held in dollars to contract. Mr. Setser writes that he suspects the dollar has actually done fairly well in recent months as a world reserve currency. "The big story," he writes, is that the total
sum of global reserve holdings has seen enormous and unprecedented growth.
A lot of that growth comes from countries with emerging economies that do not report data to the IMF, including China and Saudi Arabia, he writes. Because the emerging economies that do report to the IMF "bought three times as many dollars … as euros,"
Mr.Setser projects that a very large portion of the unreported foreign reserve growth is held in dollars. When assessing the dollar's true role as a foreign reserve currency, one also must factor in the impact of global players that the IMF does not report on, Mr. Setser writes. These include the Saudi Arabian Monetary Authority, the French banking group Crédit Industriel et Commercial, sovereign funds, and Chinese banks.
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