Clarifying the roles of the exchange rate and interest rates in the return to equilibrium

We illustrate this analysis with the case of the United States. If domestic demand is strong and there is excess demand over supply (a shortfall of savings relative to investment), two types of dynamics may appear: A dynamics where the adjustment takes place , in the short term and the long term, via the real interest rate. There is then no deterioration in foreign trade and the external debt does not rise ; A dynamics where the adjustment takes place via the real exchange rate . I nitially, foreign trade deteriorates and the external debt rises, then in the long term the external debt stabilises through a depreciation of the real exchange rate. In the United States, the adjustment is tak ing place primarily via the real exchange rate. This implies an appreciation of the dollar and a deterioration in foreign trade today, followed in the long term by a depreciation of the dollar’s exchange rate that eliminates the external deficit and stabilises the external debt ratio.