The Dazzling Dollar

Jeffrey A. Frankel

JAF

Jeffrey A. Frankel

THE REMARKABLE appreciation of the dollar since 1980 rivals the oil shocks of the 1970s as the most dramatic relative price change in the post-World War II world economy. It is widely agreed that the source of the increase in the price of the dollar is an increase in the attractiveness of dollar assets to investors around the world. But what makes U.S. assets more attractive? At the risk of being uncontroversial, I continue to believe that the increase over the last five years in the differential between real interest rates in the United States and those in other countries is the major identifiable factor. The idea is that higher interest rates attract foreign capital into the country, causing the dollar to appreciate until it has become so “overvalued” relative to its long-run equilibrium value that the market expects a future depreciation sufficient to offset the interest differential. As table 1 shows, the long-term real interest differential between the United States and a weighted average of trading partners stood at between 2.7 and 3.5 percentage points as of February 1985, depending on which of three measures of expected inflation is used. Based on the middle estimate, the differential was 2.9 percentage points, up 5.0 points from a differential of about – 2.1 percentage points in 1980. Figure 1 shows the three measures of long-term real interest differential monthly from 1979 to 1984.