Arnold Kling

Dornbusch on Exchange Rates

Arnold Kling, Great Questions of Economics
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Rudi Dornbusch has some thoughts about international macroeconomic equilibrium.

Two views about today's prevailing exchange rates exist: the dollar is overvalued dollar and the yen needs a deep depreciation. The implication of the two is an explosion upward for the Euro. But can Europe deal with such a shock, and what would happen to the US if that happened?

...A big appreciation in the euro is not on the cards. Europe's leading economies, like Germany, are a fiscal embarrassment. Their tardiness in reforming and hostility to capital creates an impression of eurosclerosis that won't attract capital.

I had a hard time following Dornbusch when I took his International Macroeconomics course at MIT, and I have a hard time following him now. He seems to be making a "tallest pygmy" argument that although the U.S. needs a weaker exchange rate in order to restore trade balance, Japan and Europe need weak exchange rates even more.

Discussion Question. Other economists, notably Brad DeLong, suggest that the world needs to "balance up," meaning that rather than have the U.S. undertake all of the international adjustment by cutting imports, other countries need to increase their domestic demand. How might this happen?

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