Welfare Implications of Exchange Rate Changes

42 Pages Posted: 13 Oct 2008

See all articles by Luis Brandao-Marques

Luis Brandao-Marques

International Monetary Fund - Monetary and Capital Markets Department

Date Written: March 11, 2008

Abstract

This paper measures the welfare implications of a depreciation of the US dollar against the euro using a dynamic equilibrium model. I calibrate a simple two-country stochastic endowment economy with trade in goods and financial assets and exogenous variations in the exchange rate. The model displays both a trade channel effect and an asset channel effect after a change in the value of the exchange rate. The welfare loss coming from the trade channel translates into the relatively higher price that consumers have to pay for imports. The asset channel effect arises from three sources. One is the traditional valuation effect associated with US debt being denominated mostly in dollars. The other two novel effects are: (1) the dollar value of investors net worth, mostly denominated in local currency, increases more in Europe than in the US; (2) asset prices change, causing a portfolio rebalancing effect which results in a fall in the share of world assets owned by the US. I show that a dollar depreciation has potentially large negative welfare effects as measured by the net present value of future consumption. After a temporary 10% depreciation of the dollar, with a half-life of one year, I calculate a 0.25% decrease in lifetime aggregate consumption for the US consumer.

Keywords: trade effect, valuation effect, wealth effect, exchange rate, incomplete markets

Suggested Citation

Brandao-Marques, Luis, Welfare Implications of Exchange Rate Changes (March 11, 2008). AFFI/EUROFIDAI, Paris December 2008 Finance International Meeting AFFI - EUROFIDAI. Available at SSRN: https://ssrn.com/abstract=1282218 or http://dx.doi.org/10.2139/ssrn.1282218

Luis Brandao-Marques (Contact Author)

International Monetary Fund - Monetary and Capital Markets Department ( email )

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Washington, DC 20431
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