Is the Real U.S. Dollar Exchange Rate Neutral

AbstractThis paper investigates the dynamic effects of the real U.S. dollar exchange rate on several macroeconomic aggregates for the United States. The literature on exchange rates suggests various scenarios for this nexus. One thesis is that the exchange rate is neutral for overall U.S. economic activity. Other theses emphasize the negative and positive effects of an and exchange rate on the economy. This research contributes to the literature in this area by employing econometric time series models that allow for the testing of the short-term and long-term effects of the real U.S. dollar exchange rate on several macroeconomic aggregates, mutatis mutandis. The empirical results are consistent with the thesis of a short-term exchange rate effect on several macroeconomic aggregates, but reject the notion of the long-term non-neutrality of the real dollar exchange rate. Econometric results are also consistent with a short-term effect only from one macroeconomic aggregate to the exchange rate and with another macroeconomic aggregate affecting the exchange rate in the long-term.Keywords: Exchange rate neutrality, International Competitiveness Ratio, CointegrationJEL Codes: F31, F41, G15IntroductionThis paper investigates the dynamic effects of the real U.S. dollar exchange rate on a group of six macroeconomic aggregates for the United States economy for the period 1975-2004. This historical period is characterized, for the most part, by a floating exchange rate regime for the U.S. dollar. However, for various sub-periods during this time span, the U.S. dollar exchange rate has been considered by policy makers as being either or undervalued, resulting in coordinated foreign exchange market interventions.A conceptual framework for discerning an exchange rate effect on the overall economy is to consider the issue in the context of an exchange rate policy triangle paradigm: each side reflecting a different policy perspective on the implication of the U.S. dollar's exchange rate on the international competitiveness of the U.S. economy. One side views periods of an dollar as a reason for the deindustrialization and exportation of domestic employment; another side considers periods of an currency as resulting in the sale of financial and real assets to foreigners at below intrinsic prices; and yet another side regards the exchange rate as being neutral. It is clear that the first two positions would ascribe to an activist exchange rate policy to correct perceived exchange rate misalignments from intrinsic value; the third view would subscribe to a non-interventionist policy towards the exchange rate.Notwithstanding the a priori positions of these three points of view, the efficient market hypothesis asserts that the U.S. dollar exchange rate under a floating exchange rate regime is a positive economic reflection of the intrinsic value of the international price of the currency. Statements of an overvalued or undervalued exchange rate reflect normative economic evaluations of a currency's international value and as such cannot be objectively resolved.Moreover, all three positions appear to discount the effect macroeconomic aggregates may have on the exchange rate. This is contrary to a widely accepted axiom among economists that a strong domestic economy begets a strong currency. It follows that what needs to be studied is the empirical evidence on the multi-faceted nexus between the exchange rate and a vector of macroeconomic aggregates. This is the contribution of this research paper to the foreign exchange literature.This research contributes to the policy debate of an exchange rate effect on the international competitiveness of the U.S. economy. Econometric time series modeling techniques test for the short-term and long-term effects of the real exchange rate on gross domestic product, gross national income, gross fixed capital formation, household consumption expenditures, and exports and imports of goods and services. …