Does A Strong Dollar Increase Demand For Both Domestic And Imported Goods?

Abstract

Rising exchange rates strengthen the dollar and lower prices on imported consumer goods. Lower import prices have two effects. (1) A substitution effect that shifts demand from domestically produced goods to imports. (2) An income effect that increases demand for imports even further. However, it also allows some income previously spent on imports, but no longer needed due to lower import prices, to be shifted to purchases of domestic goods. This paper finds that for the U.S., 1960 - 2000, the income effect overwhelmed the substitution effect. As a result, econometric results suggest declining import prices increased both import demand and demand for domestically produced consumer goods. The estimated increase in demand for domestically produced consumer goods and services was 3.4 times as large as the increase in demand for consumer imports. Also, because of the large increase in GDP resulting from growth in domestic demand, the trade deficit grew slower than domestic output of consumer goods. This finding suggests that while the trade deficit grows as a result of a strengthening dollar, the increase, as a percent of U.S. GDP, is small, about four tenths of a percent for a ten percent strengthening of the dollar.