Currency Adjustment and the U.S. Dollar

I love it when Paul Krugman posts on international trade and exchange rates - it reminds me why he is a 'first ballot Hall of Famer' economist. His post Adjustment and the dollar is a must read. A few points:

So something has to give -- specifically, the relative price of US output, and along with it such things as US relative wages, has to fall.

There are three ways this could happen: (1) deflation in the United States (2) inflation in the rest of the world (3) a depreciation of the dollar against other currencies. Leave (2) aside, on the grounds that central banks will fight it. Then the choice is between (1) and (3)...

And here's the thing: deflation is hard (ask Spain), because prices are sticky in nominal terms. How do we know that? Lots of evidence. See, for example, A Sticky Price Manifesto by Larry Ball and some guy named Mankiw. But the most compelling evidence -- familiar to international macro people, but oddly uncited by most domestic macroeconomists -- comes from exchange rates...

So, the bottom line: to narrow international imbalances, we need a lower relative price of US output. Because prices are sticky, by far the easiest way to get there is dollar depreciation.

Terrific stuff - I wish we would see more of this from Krugman.

More on exchange rates:

• Purchasing Power Parity: Link Between Exchange Rates and Inflation
• A Beginner's Guide to Exchange Rates and the Foreign Exchange Market
• Exchange Rates: What to Use as the Base?
• Analyzing the Value of the Canadian Dollar - Introducing MERT
• How Markets Use Information To Set Prices