The reasons behind the large dollar swings of the 1980s are not yet fully understood, but there is a strong presumption that US policies played a major part. The absence of an active response in Europe (and Japan) must also be taken into account, and the apparent lack of policy coordination must be a crucial part of any explanation of the swings. In Discussion Paper No. 241, Research Fellow Charles Wyplosz examines dollar swings from a European perspective assessing their effects on the European economies and investigating possible policy responses.
US price competitiveness fell by 40% between late 1979 and early 1985, only to be restored between early 1985 and late 1987. Despite the size and duration of the dollar's real appreciation, an examination of market shares reveals only a small decline in the US share of the European manufacturing market and a small increase of Europe's share of the US market. Wyplosz argues that huge real exchange rate swings apparently deliver minute effects on trade and that, at the aggregate level, concern with exchange rate movements among large industrialized blocs is likely to be exaggerated. Dollar swings might also affect Europe through the effects of terms of trade changes on income, wealth and spending, and the cumulative impact of income multipliers, but Wyplosz argues that terms of trade movements do not appear to have had a strong impact on Europe.
Europeans have complained loudly about the inflationary impact of the dollar appreciation, comparing it to a third oil shock. Wyplosz examines several possible linkages involved between European and US price levels. Goods imported from the US have a direct effect on European prices, but given their modest share of European expenditure, this channel cannot be expected to play a major role. A second possible linkage results from the demand pressure which follows dollar appreciation and a shift in world demand away from (more expensive) US goods. This shift is likely to affect European aggregate demand, but only if Europe operated under very tight capacity constraints could such a shift, spread over several years, play any major role in European inflation.
The evidence therefore suggests that the relative price, income flow and inflationary channels through which dollar swings affect Europe are all limited because the two sides of the Atlantic are relatively closed economies with only modest direct trade interactions, although financial linkages are much more powerful.
Any European expansion would therefore need to be very dramatic to have any significant effects on the US trade or budget deficits, according to Wyplosz, since both the US and Europe are relatively closed economies. Assuming that Europe's marginal propensity to import is 17%, a 10% increase in Europe's GDP would increase its imports by 1.7% of its GDP. Even if all these imports were provided (directly or via multipliers or third-country effects) by the US, such a momentous expansion would still fail to correct the US current account deficit. A more plausible shift, to 2% higher growth in Europe and 2% lower growth in the US, only improves the US current account by 0.7% of US GDP. This is hardly large enough to convince Europe to double its rate of growth if it does not already see the need for it, or if it fears inflationary pressures.
This does not mean, however, that Europe has no reason to expand. Wyplosz finds it paradoxical that in the late 1980s, Europe, with the possible exception of the UK, still fights a vanishing inflation and accepts record high unemployment. This is largely a failure of intra-European coordination, not of transatlantic cooperation. According to Wyplosz the bitter irony is that it is in the best interests of European governments to expand, irrespective of what it means for the United States even though what is best for Europe may also be what is best for the US

The Swinging Dollar: Is Europe out of Step?
Charles Wyplosz

Discussion Paper No. 241, June 1988 (IM)