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B R O O K I N G S PA P E R S O N

William C. Brainard and George L. Perry, Editors

2005

Ryan D. Nunn, Statistical Associate

Theodore Papageorgiou, Assistant to the Editors
Michael Treadway, Editorial Associate
Lindsey B. Wilson, Production Associate

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B R O O K I N G S PA P E R S O N

William C. Brainard and George L. Perry, Editors 2005

Editors’ Summary ix

Articles
OLIVIER BLANCHARD, FRANCESCO GIAVAZZI, and FILIPA SA
International Investors, the U.S. Current Account,
and the Dollar 1
Comments by Ben S. Bernanke and Hélène Rey 50
General Discussion 62
MAURICE OBSTFELD and KENNETH S. ROGOFF
Global Current Account Imbalances
and Exchange Rate Adjustments 67
Comments by Richard N. Cooper and T. N. Srinivasan 124
General Discussion 141
MICHAEL DOOLEY and PETER GARBER
Is It 1958 or 1968? Three Notes on the Longevity
of the Revived Bretton Woods System 147
Comments by Barry Eichengreen and Jeffrey A. Frankel 188
General Discussion 204
SEBASTIAN EDWARDS
Is the U.S. Current Account Deficit Sustainable?
If Not, How Costly Is Adjustment Likely to Be? 211
Comments by Kathryn M. E. Dominguez and Pierre-Olivier Gourinchas 272
General Discussion 282
DEAN BAKER, J. BRADFORD DELONG, and PAUL R. KRUGMAN
Asset Returns and Economic Growth 289
Comments by N. Gregory Mankiw and William D. Nordhaus 316
General Discussion 325
 Purpose Brookings Papers on Economic Activity contains the articles, reports,
and highlights of the discussions from conferences of the Brookings
Panel on Economic Activity. The panel was formed to promote pro-
fessional research and analysis of key developments in U.S. economic
activity. Prosperity and price stability are its basic subjects.
The expertise of the panel is concentrated on the “live” issues of
economic performance that confront the maker of public policy and the
executive in the private sector. Particular attention is devoted to recent
and current economic developments that are directly relevant to the
contemporary scene or especially challenging because they stretch
our understanding of economic theory or previous empirical findings.
Such issues are typically quantitative, and the research findings are
often statistical. Nevertheless, in all the articles and reports, the rea-
soning and the conclusions are developed in a form intelligible to the
interested, informed nonspecialist as well as useful to the expert in
macroeconomics. In short, the papers aim at several objectives: metic-
ulous and incisive professional analysis, timeliness and relevance to
current issues, and lucid presentation.
Articles appear in this publication after presentation and discussion
at a conference at Brookings. From the spirited discussions at the con-
ference, the authors obtain new insights and helpful comments; they
also receive searching criticism about various aspects of the papers.
Some of these comments are reflected in the published summaries of
discussion, some in the final versions of the papers themselves. But in
all cases the papers are finally the product of the authors’ thinking and
do not imply any agreement by those attending the conference. Nor
do the papers or any of the other materials in this issue necessarily rep-
resent the views of the staff members, officers, or trustees of the
Brookings Institution.

Correspondence Correspondence regarding papers in this issue should be addressed to

the authors. Manuscripts are not accepted for review because this jour-
nal is devoted exclusively to invited contributions.

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puter Library Center (contact OCLC subscriptions department at
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 Panel Dean Baker Center for Economic and Policy Research
members and Olivier Blanchard Massachusetts Institute of Technology
staff: William C. Brainard Yale University
J. Bradford DeLong University of California, Berkeley
Michael Dooley University of California, Santa Cruz
Sebastian Edwards University of California, Los Angeles
Peter Garber Deutsche Bank
Francesco Giavazzi Universitá Commerciale Luigi Bocconi
Paul R. Krugman Princeton University
Maurice Obstfeld University of California, Berkeley
George L. Perry Brookings Institution
Kenneth S. Rogoff Harvard University
Filipa Sa Massachusetts Institute of Technology
________
Ryan D. Nunn Brookings Institution
Theodore Papageorgiou Yale University
Michael Treadway Brookings Institution
Lindsey B. Wilson Brookings Institution

Panel advisers Martin Neil Baily Institute for International Economics

participating Richard N. Cooper Harvard University
in the Benjamin A. Friedman Harvard University
seventy-ninth Robert J. Gordon Northwestern University
conference: N. Gregory Mankiw Harvard University
William D. Nordhaus Yale University
Edmund S. Phelps Columbia University

Guests whose Henry J. Aaron Brookings Institution

writings or Ben S. Bernanke Board of Governors of the Federal Reserve System
comments Kathryn M. E. Dominguez University of Michigan
appear in this Barry Eichengreen University of California, Berkeley
issue: Jeffrey A. Frankel Harvard University
Pierre-Olivier Gourinchas University of California, Berkeley
Gian Maria Milesi-Ferretti International Monetary Fund
Richard Portes London Business School
Hélène Rey Princeton University
T. N. Srinivasan Yale University
Editors’ Summary

The brookings panel on Economic Activity held its seventy-ninth con-

ference in Washington, D.C., on March 31 and April 1, 2005. This issue of
Brookings Papers on Economic Activity includes the papers and discussions
presented at the conference. The first four articles address the position of
the United States in the global economy, an increasingly controversial sub-
ject in the research, financial, and policy communities. Since the early
1990s, U.S. current account deficits have grown almost without interrup-
tion, reaching $666 billion, or about 6 percent of GDP, in 2004. The U.S.
international investment position is now one of net indebtedness approach-
ing 30 percent of GDP, and in recent years a substantial portion of the
buildup in net debt has come in the form of additions to dollar reserves by
foreign central banks. Some observers see the present situation as unsus-
tainable and warn of an abrupt depreciation of the dollar, which could
destabilize financial markets and disrupt the global economy. Others are
more sanguine, arguing that the present situation reflects the relative
strength of the U.S. economy, consumer and business preferences, and
rational financial decisions, all of which could evolve so as to make any
needed adjustments gradual.
Each of the four articles takes a different approach to analyzing the sit-
uation, focusing on issues that the authors see as key. The first article
models portfolio choices and how they moderate the pace of adjustment in
exchange rates and current accounts. The second stresses the relative price
changes that will be needed, both in the United States and abroad, to move
the U.S. current account toward balance. The third considers the motiva-
tions of policymakers in China and elsewhere for accumulating dollar
reserves. The fourth assesses the likelihood of an abrupt depreciation of the
dollar and the economic instability that might result in the United States
and abroad. The volume concludes with an article on the possible impact of
slowing labor force growth on stock market returns.
ix
 x Brookings Papers on Economic Activity, 1:2005

The u.s. international investment position is affected by develop-

ments in both foreign trade and international capital flows—the market for
imports and exports of goods and services and the market for foreign and
domestic assets. The sustainability of the U.S. current account deficit and
the consequences of reducing that deficit depend on features of both those
markets. Most economic models that have been used to analyze the cur-
rent account deficit assume imperfect substitutability between foreign and
domestic goods and services but perfect substitutability between foreign
and domestic assets. These assumptions carry strong implications for how
the economy adjusts to new developments. In the first article in this
volume, Olivier Blanchard, Francesco Giavazzi, and Filipa Sa provide a
distinctive analysis that allows for imperfect substitutability between
domestic and foreign assets and between domestic and foreign goods. With
this feature, movements in exchange rates and asset prices have poten-
tially important effects on the portfolios of international investors and
strong implications for the speed with which exchange rates adjust to
shocks. Compared with popular discussion and with earlier, simpler mod-
els, this rich specification provides a better understanding of past develop-
ments in the U.S. current account balance and the dollar exchange rate
and a more realistic framework for assessing future prospects.
In its simplest form the authors’ model has just two regions—the United
States and the rest of the world—each of which supplies interest-bearing
assets. The wealth of each region is given by the value of domestic assets
plus net claims on foreigners. Investors diversify their portfolios, holding
both foreign and U.S. assets, but exhibit home bias: given equal expected
returns, they place a larger fraction of their wealth in domestic than in for-
eign assets. As a result, a shift in wealth to foreigners reduces the demand
for U.S. assets, causing the dollar to depreciate. Similarly, an increase in
private or government demand for dollar assets causes the dollar to appre-
ciate. Because of imperfect substitutability, the relative returns on foreign
and U.S. assets can vary with changes in relative supplies or shifts in the
distribution of world wealth, and uncovered interest parity does not hold.
In the model the effects of a depreciation on the path of the current
account balance and changes in U.S. net foreign indebtedness are conven-
tional. The current account balance is the sum of the trade balance and net
interest earnings. Dollar depreciation improves both, immediately reducing
the dollar value of net interest payments and eventually reducing the U.S.
trade deficit. Changes in U.S. net foreign indebtedness reflect the sum of the
William C. Brainard and George L. Perry xi

current account balance and the revaluations of U.S. and foreign portfo-
lios that arise from exchange rate movements. In the real world, asset val-
ues and therefore net debt will also change with changes in domestic
interest rates, but the model ignores these so as to focus on exchange rate
movements, which are the key for understanding the model’s distinctive
implications.
Whereas the response of the current account in the model is quite famil-
iar, the effect of depreciation on asset demands is quite different than in
conventional models where assets are perfect substitutes. Depreciation of
the dollar reduces U.S. net indebtedness directly, increasing the dollar value
of foreign assets held in U.S. portfolios while decreasing the value of U.S.
assets in foreign portfolios. If assets were perfect substitutes, these changes
in portfolio shares would be of no importance, and the expected returns on
U.S. and foreign assets would always have to be equal. With fixed domes-
tic interest rates, the expected change in exchange rates would then be zero.
In such a world, real exchange rate changes are always unexpected. With
imperfect substitutability, in the absence of compensating changes in
expected relative rates of return, investors in both regions will want to
rebalance their portfolios following an unexpected exchange rate move-
ment. Thus an unexpected depreciation of the dollar in response to a trade
shock actually increases the relative demand for U.S. assets, reducing but
not reversing the depreciation. Unlike in the case of perfect substitutability,
the expected returns on U.S. and foreign assets do not have to be the same
after the initial adjustment. Rather than jump all the way to a new equilib-
rium from which no further change is expected, the dollar undergoes a
sharp initial, unexpected depreciation followed by a more gradual, expected
depreciation. The expected depreciation merely reduces the desired shares
of U.S. assets in investors’ portfolios rather than causing massive flight
from dollars. The rate at which the dollar depreciates after its initial
response to an adverse shock depends on the elasticity of asset demands
with respect to the relative rates of return: the lower the elasticity, the more
gradual the depreciation and the improvement in the current account.
Since observed outcomes are always the result of past and present
shocks, the dynamics of adjustment toward the steady state are of particu-
lar interest. The authors analyze two representative cases. In response to a
shock that increases the trade deficit, such as an increase in U.S. economic
activity or an enlarged preference for imports, there is, as explained above,
an initial, unexpected depreciation of the dollar, followed by a gradual
 xii Brookings Papers on Economic Activity, 1:2005

further, anticipated depreciation and an increase in U.S. net debt. How

much of the depreciation is immediate and how much takes place on the
subsequent path of adjustment depend on the response of trade to the depre-
ciation and on the responsiveness of portfolio demands to the anticipated
changes in relative rates of return. The less substitutability between for-
eign and U.S. assets, the smaller will be the initial depreciation, and the
more rapid the subsequent depreciation. However, the eventual deprecia-
tion in the new steady state is the same, and large enough to generate a
sufficient trade surplus to offset the higher interest payments on the larger
debt.
The second case involves a response to a shock that increases the
demand for U.S. assets, such as an increase in demand by foreign govern-
ments. In this case the reduced supply available to private portfolios leads
to an initial dollar appreciation. This enlarges the trade deficit, adding to the
future flow of dollar assets supplied. The subsequent path is one of a grad-
ual, anticipated depreciation and increase in net debt. Despite the initial
favorable portfolio shift, the new steady state requires a weaker dollar,
since, as in the previous example, the trade surplus must be larger to offset
the interest payments on the now-larger debt.
The authors suggest that the U.S. experience of recent years can be
understood as responses to shocks like those just described. In their view a
shift in private portfolio preferences toward U.S. assets led initially to an
appreciation of the dollar. Independently, a shift in the preferences of U.S.
consumers toward foreign goods worsened the trade balance by more than
can be explained by exchange rate and income effects. As described above,
both kinds of shifts predict an eventual sustained dollar depreciation to a
level below that prevailing before the shift. Although the accumulation of
reserves by foreign governments has supported the dollar against some cur-
rencies, the authors argue that the United States has entered the deprecia-
tion phase of the adjustment that their model predicts.
To assess future prospects, and in particular how large an eventual dollar
depreciation should be expected, the authors quantify their model using
estimates of present wealth, assets, portfolio shares, and net debt for the
United States and the rest of the world, together with estimates of model
parameter values based on existing empirical studies and some assumptions
about adjustment speeds and policy preferences. For 2003 these estimates
include the following: U.S. assets of $36.8 trillion, foreign assets of $33.3
trillion, and U.S. net foreign debt of $2.7 trillion; 77 percent of U.S. wealth
William C. Brainard and George L. Perry xiii

invested in U.S. assets, and 71 percent of foreign wealth invested in foreign

assets. In the model these shares imply that a transfer of one dollar of U.S.
wealth to foreigners leads to a decrease of 48 cents in demand for U.S.
assets. The estimated trade elasticities imply that a 1-percentage-point
reduction in the ratio of the trade deficit to GDP requires a depreciation of
15 percent.
Armed with these quantifications of their model, the authors use it to
predict where the U.S. international position is headed. First they calcu-
late the exchange rate adjustment that would be needed to maintain the pre-
sent net debt position as a steady state, under the implicit assumption that
the economy has already adjusted to past shocks, and introducing no impor-
tant asymmetries between foreign and U.S. interest rates or growth rates. In
this case the ratio of the current account deficit to GDP that can be sustained
indefinitely is given by the economy’s growth rate times the ratio of net
debt to GDP. With 3 percent annual growth in U.S. GDP, maintaining a
net debt ratio of about 25 percent requires reducing the current account
deficit from its present 6 percent to 0.75 percent of GDP. With annual inter-
est rates at 4 percent, this requires a depreciation of the dollar of 56 percent.
The authors note some important qualifications to this calculation. To the
extent that the present current account deficit reflects J-curve effects in
response to the dollar’s recent depreciation (in which a depreciation at
first worsens the current account balance before improving it), it over-
states the additional depreciation required. Noting that the current
account continued to worsen for nearly two years after the depreciation
of the mid-1980s began, they estimate that a similar path this time would
mean that only a 34 percent further depreciation is needed. They also
note that if the U.S. net debt ratio were allowed to stabilize at a higher
level than the present, the equilibrium current account deficit could be
larger.
As an alternative way to assess the dollar’s prospects, the authors under-
take dynamic simulations of the response to trade and portfolio shocks in
which the equilibrium debt-to-GDP ratio is endogenous. Simulating per-
manent shocks to the trade deficit, they calculate that a 1-percent-of-GDP
shift away from U.S. goods increases the equilibrium net debt ratio by
17 percentage points and causes the dollar to depreciate by 12.5 percent.
Simulating shifts in asset preferences, they calculate that, in response to a
shift that raises the share of U.S. assets in both U.S. and foreign portfolios
by 5 percentage points, the dollar initially appreciates and then eventually
 xiv Brookings Papers on Economic Activity, 1:2005

reaches an equilibrium depreciation of 15 percent with a 35-percentage-

point increase in the net debt ratio. A striking feature of both simulations
is how long it takes to reach equilibrium. After fifty years the adjustment
is still far from complete, with the dollar still above its pre-shock level after
the shift toward dollar assets, and the depreciation only about two-thirds
complete after the shift in trade away from U.S. goods. Although they ques-
tion the realism of these extraordinary adjustment periods, the authors
believe they do correctly show that the adjustment process can be very
long.
Such gradualism contrasts with the predictions of some observers that
the dollar is likely to fall abruptly in the near future. To evaluate this pos-
sibility, the authors examine under what conditions their model would pre-
dict a faster depreciation than in their baseline simulations. As discussed
above, the anticipated rate of depreciation is faster, the less substitutability
there is between U.S. and foreign assets, with the extreme case of constant
shares providing an upper bound. For this case the authors show that the
anticipated rate of depreciation depends on the change in the ratio of U.S.
net debt to U.S. assets: a faster rise in the debt ratio requires a more rapid
depreciation to maintain portfolio balance. In a situation where the net
debt ratio is rising by 5 percent a year, and with a ratio of gross assets to
GDP of 3—both rough approximations of recent experience—they calcu-
late an anticipated rate of depreciation of 2.7 percent a year. This estimate
is based on anticipated portfolio shares remaining constant. In the model,
however, the rate of depreciation will also be affected by any anticipated
change in the relative demand for U.S. assets—a shock imposed on top of
the constant-shares assumption in the previous calculation. If the demand
for shares of U.S. assets in foreign or domestic portfolios is expected to
decline, the expected depreciation can be much faster. For example, if the
share of U.S. assets demanded in foreign portfolios is expected to decline
by 2 percentage points over the coming year, the expected depreciation
rises to 8.7 percent.
The authors note that there is considerable disagreement about the share
of U.S. assets that foreigners will want to hold in the future. Some
observers argue that foreign central banks will continue their recent policy
of adding to dollar holdings. Others see a latent demand for U.S. assets
by private Chinese investors who are currently restrained by capital con-
trols. Although the authors consider these outcomes possible, they find it
more likely that the relative demand for U.S. assets will decline in the near
William C. Brainard and George L. Perry xv

future, as foreign central banks stop pegging the dollar or diversify their
portfolios away from U.S. assets, or both. The calculations just provided
for a shift in shares are then relevant. The authors also observe that the
longer the peg continues, the larger both the initial and the eventual depre-
ciation will be.
The depreciation of the dollar since its 2002 peak has been very uneven
against different currencies: the dollar has fallen 45 percent against the
euro, 25 percent against the yen, and not at all against the Chinese ren-
minbi. To investigate how future adjustments would impact each of these
important currencies, the authors extend the essentials of their model to
include four regions rather than just two. The analysis focuses on the inter-
relations among the United States, Japan, the euro region, and China, ignor-
ing the rest of the world. The authors assume that half the U.S. current
account deficit is with China and a quarter with each of the others, values
that approximate recent actual deficits. These deficits transfer wealth, and
how that wealth is invested drives exchange rate movements. The model
allows for two special features of the Chinese economy: capital controls
on private financial capital inflows and outflows, and the pegging of the
renminbi to the dollar. Asset preferences in each of the other three regions
are allowed to differ, but all are assumed to have the same marginal
response to changes in expected returns, and interest rates measured in the
domestic currency are assumed to be the same in each. The authors illus-
trate the main forces at work using a simplified version of the model in
which asset demands do not depend on expected returns. For a given U.S.
current account deficit, the more dollar assets China holds, the smaller is the
appreciation of the euro and yen. Surprisingly, if China holds only dollar
assets, a U.S. current account deficit actually causes the dollar to appreciate
against both the euro and the yen, since most of the U.S. deficit is with the
region with extreme dollar preferences. If only Japan accumulates dollars,
both the yen and euro appreciate, with the yen appreciating more. In this
case a transfer of wealth to Japan leaves the real effective exchange rate of
the euro unchanged, as the euro rises against the dollar and falls against
the yen.
The authors also use this framework to analyze the effects of prospective
changes in China’s policies. If China stops pegging but maintains capital
controls, it will have a zero current account surplus, which would require an
appreciation of the renminbi against the dollar. Reserve accumulation
would then cease, and the U.S. current account deficit would have to be
 xvi Brookings Papers on Economic Activity, 1:2005

financed entirely by investors in Japan and Europe. This shift in wealth

accumulation away from the region with extreme dollar preferences would
strengthen the euro and the yen against the dollar. A diversification of
China’s portfolios away from all dollars would have a similar effect. The
same qualitative results are also found in simulations that allow for the
endogenous response of portfolio choices to expected relative returns.
Thus, in the authors’ analysis, China’s pegging to the dollar has limited
the appreciation of the euro and yen against the dollar, in contrast to the
opinion of some commentators that it has increased the pressure on the euro
to appreciate.
The authors briefly address the connections between domestic fiscal and
monetary policy and the U.S. international position. As the U.S. current
account and budget deficits have risen together in the past five years, they
have frequently been paired in discussions of needed policy changes, with
some commentators identifying the latter as the cause of the former and
calling for reduced fiscal deficits as a possible substitute for depreciation.
The authors point out, however, that these are complementary changes
rather than substitutes, with interest rates a key link between the two. With
the dollar depreciating under the pressure of excessive current account
deficits, demand for U.S. output expands, requiring a combination of higher
interest rates and fiscal deficit reduction to maintain domestic balance.
Because higher interest rates would limit the immediate depreciation while
requiring more in the future, smaller budget deficits are the appropriate bal-
ancing change. But, if fiscal policy is tightened without dollar depreciation,
the economy is likely to weaken.
The authors conclude by summarizing the implications of their findings
for understanding the recent past and projecting the future. In their view the
path of the dollar since the late 1990s has been supported by increases in the
demand for U.S. assets, first by private investors for equities and more
recently by central bank demands for bonds. A shift in preferences away
from U.S. goods has also contributed to growing trade deficits in this
period. Imperfect substitution in portfolios helps account for the gradualism
of exchange rate adjustments and for the persistent U.S. current account
deficits that have been observed. The model predicts that a gradual depre-
ciation of the dollar will be the prevailing trend for an extended period.
However, if the expected demand for U.S. assets falls, as it would if cen-
tral bank policies changed, the decline in the dollar would be more abrupt.
Similarly, the gradual depreciation could be interrupted by a temporary
William C. Brainard and George L. Perry xvii

appreciation if investors’ preferences shifted toward dollar assets, although

the resulting larger trade deficits would lead to an even larger depreciation
eventually. For the same reason, a rise in U.S. interest rates would
strengthen the dollar only temporarily and require a larger depreciation in
the longer run. The authors thus reason that a better policy mix would
combine a reduction of budget deficits with a reduction of interest rates to
maintain growth.
Turning to China, the authors argue that eventually the government will
find it difficult to continue to sterilize interventions and will abandon its
dollar peg. But the longer the peg will have supported the dollar, the larger
the eventual dollar depreciation will have to be in order for the United
States to service the larger accumulated foreign debt. The authors also
observe that a large dollar depreciation would not necessarily be a major
problem for the United States. By improving the trade balance, it would
permit a reduction of budget deficits without causing a recession. However,
dollar depreciation might pose a bigger problem for Japan and Europe,
which are already growing slowly and which have limited scope for expan-
sionary stabilization policies.

Some lay commentators have suggested that eliminating the federal

budget deficit would automatically reduce today’s massive deficit in the
U.S. current account. In a 1987 paper, James Tobin identified this as one
of eight “myths” about exchange rates and the current account, because it
ignores the fact that improvements in the current account balance have to
be earned in competition with foreign producers and will, if employment
is to be maintained, require changes in exchange rates and terms of trade. In
the second article in this issue, Maurice Obstfeld and Kenneth Rogoff pur-
sue this theme. They first provide a wide-ranging discussion of recent eco-
nomic developments, concluding that the U.S. current account deficit will
before long have to be substantially reduced, if not eliminated. They then
model the price adjustments that would be required to change import and
export patterns in the United States and abroad so as to eliminate or sub-
stantially reduce the U.S current account deficit without reducing aggregate
economic activity.
Although most analysts recognize that improving the trade balance will
require a real depreciation of the dollar, less attention has been paid to the
likely need for changes in the relative price of traded and nontraded goods
both in the United States and among its trading partners. In earlier work
 xviii Brookings Papers on Economic Activity, 1:2005

Obstfeld and Rogoff have argued that these adjustments are, if anything,
likely to be larger than the changes in the relative prices of domestic and
foreign tradable goods—the terms of trade. It is easy to show why this
might be so. Without changes in production anywhere, eliminating the U.S.
current account deficit, which today stands at roughly 6 percent of GDP,
implies something like a 20 percent reduction in U.S. consumption of
traded goods. Assume for simplicity that the traded goods of different coun-
tries are perfect substitutes, so that exchange rate changes do not change the
relative price of different traded goods, but only the prices of nontraded
goods relative to traded goods within countries. Then, with a unitary elas-
ticity of substitution between traded and nontraded goods and hence con-
stant shares, this 20 percent reduction in consumption of traded goods
requires a fall in the price of nontraded goods relative to traded goods of the
same percentage. In foreign countries, where, under these assumptions,
consumption of traded relative to nontraded goods has to rise, the relative
price of the latter must also rise. If the traded goods of different countries
are not perfect substitutes, the calculations are more complicated, and the
required terms of trade and real exchange rates need to be determined
simultaneously. But the qualitative nature of the needed adjustment is the
same.
To capture the salient features of the current international environment,
the authors develop their model by assuming three world regions, repre-
senting the United States, Asia, and Europe, all linked by trade and by a
matrix of international asset and liability positions. This enables the authors
to model asymmetries in the trading relationships between regions and to
analyze the implications of dividing the improvement in the U.S. trade
account between Europe and Asia in different ways. The model is short run
and static. Each region produces two goods: a nontraded good consumed
only by its residents, and a traded good that is both consumed domestically
and exported. Hence there are a total of six goods in the world economy. The
regions are endowment economies with flexible prices, implicitly assum-
ing factor immobility between sectors and full employment.
The preferences of consumers, and in particular the elasticities of sub-
stitution among the different goods, play the central role in determining
price adjustments associated with changes in the current account. Four
commodities are available to consumers in each region—their own region’s
traded and nontraded goods and the traded goods of the other two regions.
The authors model goods preferences in each region by means of two
William C. Brainard and George L. Perry xix

constant-elasticity-of-substitution (CES) consumption indexes: the first is

an index of overall traded good consumption derived from a bundle of the
three traded goods, and the second aggregates this index with nontraded
good consumption to provide a utility measure for total consumption.
Although the functional form of these CES functions is the same across
regions, the weights on the commodities differ. In particular, the traded
goods index displays home bias: consumers in each region have a relative
preference for the traded good that it produces and exports. Even though the
law of one price (individual traded goods have the same price everywhere)
holds, the price indexes for each region’s bundle of traded goods will dif-
fer across regions, because each depends on the region’s own consump-
tion weighting of individual traded goods. This implies that an increase in
a region’s income and expenditure improves its terms of trade, raising the
price of its exports relative to that of its imports. The United States and
Europe exhibit mirror symmetry in their preferences for each other’s traded
good but place the same weight on the Asian traded good. Asia meanwhile
weights the U.S. and the European traded goods the same, and the model
allows the weight it places on those goods to be changed, reflecting changes
in openness to trade. Whereas the weights on different goods thus differ
across regions, elasticities of substitution among goods are assumed to be
the same for all regions. The authors review a range of empirical studies
to arrive at informed judgments about the size of these elasticities. In their
baseline calculations the elasticity of substitution among tradables is
assumed to be 2, implying that, ceteris paribus, a 10 percent change in the
consumption of, say, an Asian import to the United States would be asso-
ciated with a 5 percent change in its price relative to that of the U.S. traded
good. The elasticity of substitution between nontraded goods and the index
of consumption that aggregates the three traded goods is assumed to be 1,
as in the simple example above.
Given these preferences, the authors can solve for the prices that equate
demand to supply for any global allocation of the six commodities. The
bilateral terms of trade are simply the relative prices of any two regions’
traded goods. Given the assumption of CES utility, the authors compute
exact price indexes for each region’s consumption bundle of traded goods
and for its overall consumption. Ratios of the latter give the corresponding
bilateral real exchange rates.
As noted earlier, even though the law of one price holds, the price
indexes for the bundle of traded goods differ across regions because of
 xx Brookings Papers on Economic Activity, 1:2005

differences in consumption weighting of the three traded goods. The

authors assume that each region’s bundle of traded goods has a 0.25 weight
in total consumption. This means that a change in a region’s bilateral real
exchange rate is 0.25 of the change in the region’s relative price index for
traded goods. That is, changes in the terms of trade, through their differing
effects on regions’ price levels for traded goods, can be traced directly to
real exchange rates. For example, if the price of the U.S. traded good falls
relative to the price of Europe’s traded good—an improvement in Europe’s
bilateral terms of trade—the relative price of the United States’ traded
goods index will also fall. Hence there will be a real depreciation of the dol-
lar relative to the euro.
Most of the burden of reducing the U.S. current account deficit has to
be borne by U.S. consumers reducing their consumption of traded goods,
but part of the adjustment is accomplished through valuation effects. The
United States is a net debtor, with its liabilities predominantly denominated
in dollars and more than half of the foreign assets held by U.S. residents
denominated in foreign currencies. Depreciation of the dollar therefore
actually decreases U.S. net indebtedness. Although this decrease in U.S. net
worth might be expected to affect demand gradually over time, it has an
immediate effect on the current account. Since foreign-denominated U.S.
assets exceed foreign-denominated U.S. liabilities, and interest payments
are largely denominated in the same currency as the underlying asset, the
dollar value of U.S. net interest receipts rises with a depreciation.
To estimate the effect on the terms of trade and real exchange rates of
reducing the U.S. current account deficit by 5 percent of GDP, the authors
have to make assumptions about how the offsetting reduction in current
account surpluses is distributed between Europe and Asia. They consider
three scenarios: a global rebalancing scenario, where the current accounts
of all three regions go to zero; a “Bretton Woods II” scenario, where Asia’s
currencies remain pegged to the dollar (a hypothesis analyzed at length in
the paper by Michael Dooley and Peter Garber in this volume); and a muted
version of the latter, where Asia maintains its current account surplus so
that a reduction in Europe’s surplus just balances the U.S. deficit reduction.
Given the assumed baseline elasticities, the changes in consumption
implied by global rebalancing imply very large real exchange rate changes.
The euro appreciates in real terms by over 28 percent, and the Asian cur-
rencies by over 35 percent. The greater real appreciation for Asia reflects
the fact that, initially, Asia has a much larger surplus than Europe, so that
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