Bubble trouble 2 level 588/7/2023 See Krugman (2007) for a mathematical exposition. Glossing over many details, a 'generic' portfolio balance model of the exchange rate lets us evaluate investor expectations. A simple model of the relationship between the path of the exchange rate and the path of external debt can assist in assessing the likelihood that investors are naively chasing the Road Runner off the cliff. What constitutes a feasible adjustment path? The key criterion is that the dollar must fall quickly enough to avoid US external debt reaching an unsustainable level. Coyote' moment comes when they realise that their expectations are inconsistent with any feasible adjustment path. Coyote' moment, his belief that he’s on solid ground prevents him from falling. Coyote' moment – a reference to the Warner Brothers’ cartoon where a greedy, shortsighted coyote chases a roadrunner off a cliff but doesn’t start falling until he looks down and realizes he’s left solid ground. That the markets are due for what Krugman calls a 'Wile E. The only reason to predict a sudden dollar plunge is if we believe today's capital flows are driven by investor myopia. Under the ‘gradual scenario’, the adjustment process is smoothed as dollar assets become more attractive while the greenback drops towards its sustainable level. Investors should see it coming, and this will dampen their shift into dollars. Standard asset-price logic, however, argues against this sort of anticipated sudden depreciation. Thus, when investors reach their desired holdings, there will be a drop off in capital flows into the United States, leading to an abrupt decline in both the current account deficit and the value of the dollar. But the capital flows needed to maintain an increased dollar share are much smaller than those needed to achieve it. Here is the basic idea underlying dollar ‘plunge scenarios.’ Foreign investors have long demonstrated an increased appetite for US assets, moving a greater share of their portfolios into dollars and thus generating large capital flow into the US. After all, isn’t the avoidance of such jumps one of the reasons we abandoned the Bretton Woods fixed-exchange system for a floating regime? So why are there modern fears of a sudden discrete drop in the dollar? Many analysts hope that the necessary real depreciation of the dollar might be gradual. 1 A trade deficit this big cannot persist indefinitely. In the minds of most mainstream international economists, there is never much doubt that the dollar must eventually decline significantly.
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