The U.S. Current Account Deficit and the Dollar: Another Implication of an Incomplete Pass-Through

Abstract

This paper examines the possibility of the collapse of the nominal dollar accompanying the U.S.external adjustment. Based on a sticky-price dynamic general equilibrium two-country model, we show that due to the recent decline in the exchange rate pass-through to import prices, the dollar need not depreciate to a large extent. Only when the intratemporal substitutability between U.S. and foreign goods is sufficiently larger than unity and the intertemporal substitutability of consumption is sufficiently near unity, will a sharp depreciation occur with a shrinking of the U.S. external deficit. However, when the intratemporal substitutability is only slightly larger than unity and the intertemporal substitutability is sufficiently near zero, the U.S. external adjustment can occur with a moderate depreciation of the nominal dollar. Both the existing empirical results about these parameters and the recent movements of the U.S. current account and the dollar suggest that we cannot reject the latter scenario.