Exchange rate effects on agricultural trade

Journal of Agricultural and Applied Economics, Aug 2002 by Orden, David

With sustained appreciation of the U.S. dollar over the past 4 years, the exchange rate has again taken on importance for agriculture. This overview paper revisits the analysis of exchange rate impacts, reviewing the relevant conceptual arguments, summarizing the evidence economists and agricultural economists have marshaled from the 1970s and the 1980s and from several more recent papers, presenting some illustrative recent empirical analysis of exchange rate effects, and briefly examining the detrimental consequences that sustained appreciation of the dollar is having on U.S. farm policy.

Key Words: agricultural policy, agricultural trade, exchange rate

JEL Classifications: F31, Q17, Q18

When the United States abandoned the Bretton Woods agreement on relative fixity of exchange rates in 1973, a new era of international capital mobility was launched, and the rules of the game for macroeconomic interdependence among nations were altered. Twenty years earlier, Milton Friedman had argued in his classic article "The Case for Flexible Exchange Rates" that open markets for currencies were the least disruptive mechanism for managing adjustments to changes affecting international payments. That view seemed to have finally come into its time. Yet, looking back from a vantage point 30 years after the United States gave up its fixed exchange rate, the economic turmoil that followed the initial devaluation and subsequent floating of the dollar against other major currencies was unlikely to have been fully anticipated. The turmoil included, for the United States, substantial inflation through the 1970s, then movements in the real exchange ratesequential appreciation followed by depreciation during the 1980s-in excess of 40% over periods of several years. Forty percent is a significant realignment in relative prices, and several years is long enough to force economic adjustments.

For agriculture, the "new macroeconomics" of the world economy has had substantial implications. Nominal agricultural prices skyrocketed, along with other primary commodity prices, early in the 1970s, with inflationary monetary policies and dollar flexibility being at least partly responsible. International capital flows expanded after two decades of slow growth. The U.S. trade deficit turned increasingly negative, but agricultural exports, particularly exports through commercial channels (not foreign aid), rose strongly through the 1970s. By the late 1970s, agricultural exports were up, but real agricultural prices were down. Things got much worse when the dollar began to appreciate beginning in 1980. Exports fell in value by nearly one third by 1985, and with high interest rates, land prices could not be sustained. In the ensuing farm financial crisis, supply control interventions and farm program fiscal costs were driven to record levels.

One view that emerged from this period of turbulence was that macroeconomic policy effects on agriculture, particularly effects delivered through the exchange rate, can swamp those of agricultural policy. Consistent with this view, stability was restored to the U.S. agricultural sector only when an effort to bring down the value of the dollar after 1985 essentially reestablished its pre-1980 real value (see Figure 1). Farm export began to increase again, farm income strengthened, and the portion of that income coming from government transfers declined. The attention of the farm business community and policy establishment turned to other concerns, among them the General Agreement on Tariffs and Trade negotiations and regional integration under the North American Free Trade Agreement. In domestic policy, the 1996 farm bill took steps toward reduced intervention in agricultural production and raised the possibility of, but did not guarantee, reduced future income transfers to the farm sector (Orden, Paarlberg, and Roe).

After 9 years of relative exchange rate stability from 1988 to 1996, we are now in the fourth year of a second period of sustained appreciation of the U.S. dollar. The dollar's rise in value since 1997 began with the Asian financial crisis and recession, followed by the devaluation and floating of the Brazilian currency. It continued with the weakening of the euro since its launch as a common currency, the depreciation of the dollars of Canada, Australia, and New Zealand, and, recently, the devaluation of the Argentine peso. The result of these various exchange rate movements has been a broad strengthening of the U.S. dollar relative to the currencies of our competitors and customers in agricultural markets. Shortterm exchange rate fluctuations can be hedged against in currency futures markets, and economies should (and can) adjust to their equilibrium long-term exchange rate levels. However, intermediate-length periods of sustained, but not permanent, appreciation or depreciation cause difficulties for economies in which production and trade adjustments are not costless.

With the dollar's appreciation, the exchange rate has again taken on importance for U.S. agriculture. This overview paper revisits the analysis of exchange rate impacts. I take three thrusts: (1) reviewing the relevant conceptual arguments, (2) summarizing the evidence economists marshaled from the 1970s and the 1980s and from several more recent papers, and (3) presenting some recent illustrative empirical analysis of exchange rate effects. This leads me to briefly consider the detrimental impact that sustained appreciation of the dollar is having on U.S. farm policy.