As I read the papers and magazines and even the journals on exchange rates and
trade balances, I have wanted to comment, but held off until completing a report
on this very topic. Now that several months of research and writing have ended,
it is time to share some of what I have learned. (For the complete report, see
JEI Report, August 18, 1995. You can even subscribe at the low, subsidized price

of $80 for 48 weekly issues.) As a note of humility, let me confess that until
spending months of solid study on this subject, my own understanding was quite
incomplete and confused, so it is far from my intent to criticize anyone for
understandable lapses in rigor, logic, or evidence.

The questions I addressed were what accounted for the 425 percent appreciation
of the yen against the dollar since exchange rates floated in 1973, and why had
trade imbalances persisted despite the changes in exchange rates. First,
differences in relative inflation rates account for about two-thirds of the
change in currency prices. Using 1973 as a base year (the external accounts in
both countries were more or less in balance and purchasing power parity of GNP
equaled the exchange rate in Japan) and applying price changes in manufacturing
(a proxy for tradable goods), the 1995 exchange rate would be 127. The real
question is why inflation-adjusted exchange rates changed. IMF trade-weighted,
inflation-adjusted, multilateral exchange rates show the dollar depreciating on
the average 1.2 percent annually from 1975 to mid-1995, and the yen appreciating

2.8 percent.

Here is why. The U.S. has run a current account deficit since 1980 because its
aggregate consumption by households, business, and government is greater than
its aggregate production (or the income generated by that production). A little
algebra turns this into the familiar statement that aggregate savings is less
than total investment. (The reverse is true for Japan.) If a country consumes
more than it produces, the stuff has to come from somewhere, short of miracles.
Moreover, someone must finance this excess of consumption. A trade deficit is
necessarily accompanied by a capital inflow.

The persistent U.S. deficit and Japanese current account surplus lead to a
buildup of foreign debt and foreign assets, respectively. Interest or other
payments will flow from these foreign assets. (HERE IT COMES.) In order to make
these payments, the borrowing country (U.S.) has to export more and import less
to pay the costs of its borrowing. The dollar has to depreciate in real terms to
accomplish this. Reverse the story for the yen. American net investment income
from abroad went from $33 billion in 1981 to a negative $10 billion in 1994 -- a
$ 43 billion shift. Japan went from zero net investment income to $40 billion in
receipts last year.

Did the changes in exchange rates do the trick? You bet! Trade volume figures,
which adjust for price and exchange rate changes, show that U.S. exports have
climbed almost 5 percent a year since 1985 while Japanese exports edged up only
about 1 percent annually. American imports grew at a 3.7 percent rate and
Japanese imports at 4.7 percent.

Rather than being paradoxical, trade imbalances and long-run currency changes
are cause and effect. The yen has gone up and the dollar down BECAUSE of their
current account imbalances.

Hope to see you all again real soon.

Arthur Alexander, Japan Economic Institute, Washington, DC.