2008c) “How Falling Exchange Rates Have Affected The U.S. Economy And Trade Deficit

Falling exchange rates reduce the purchasing power of the dollar, increasing import prices. Higher import prices have two effects. (1) A substitution effect that shifts demand from imported to domestically produced goods. (2) An income effect that reduces the total amount of real income available for spending on domestic goods and foreign goods. Based on U.S. 1960- 2000 data, this paper estimates an econometric model that finds that the income effects of falling exchange rates overwhelms the substitution effects, causing a net negative influence on the GDP and income. Results indicate demand for both imported and domestic consumer and investment goods is adversely affected because the income effect is so dominant. For investment goods, there was a substitution effect into imported goods when import prices rose due to a falling exchange rate, presumably because the negative income effect so reduced income that demand was pushed toward cheaper imports, despite the fact that their own prices had recently risen, causing the U.S. real income decline. Declining real income also caused decreased demand for domestically produced investment goods, presumably for the same reason. For consumer goods, the substitution effect stimulated domestic demand, but was more than offset by the negative effects of declining income. The decrease in demand for domestic goods and services was 3.5 times as large as the decrease in demand for imports. In short, the trade deficit appears to fall far less than the GDP whe