In the real world however, matters are more complicated First a drop in the exchange rate does not necessarily lead to an equivalent rise in the price of imported goods. this is partly because the final price of an imported good includes numerous costs such as distribution and marketing that are not affected by the exchange rate. Second, many countries that export to the United States (especially Asian ones) price their goods in dollars. Since these exporters are the effect of a drop in the dollar by cutting their profits rather than raising the price en absorb usually extremely keen to maintain their share in the world's biggest market, they often absorb Economists reckon that in the 1990s only about half of an exchange-rate change had worked its way through to manufacturing import prices after a year. Over a shorter period the effect can be even less. In the year to May, says Michael Rosenberg, chief currency strategist at Deutsche Bank, import prices to America, excluding oil, rose only 0.9%o, even though the trade-weighted dollar fell by 6%. But even if prices do move, spending patterns may remain much the same for a while, because consumers tend to be slow to adjust their spending in response to price changes. It also takes firms time to change orders and production levels. And even in the long run the impact on imports of a drop in the dollar is weaker than that of a drop in income. According to calculations by Ms Johnson and Messrs Hooper and Marquez, a 1% drop in the dollar reduces Americans demand for imports by only 0.3% in the long term. a 1% drop in income on the other hand, reduces imports by 1.8%. So if a drop in the dollar is to make much of a dent in the trade deficit, it will have to be really big But just how big? The exact estimates differ, depending on how economists construct their models, but virtually all the numbers are startling. In perhaps the most optimistic analysis, Fred Bergsten of the Institute for International Economics reckons that the dollar needs to fall by another 15-20% on a trade-weighted basis to bring America' s current-account deficit down to 3% of GDP. His calculation assumes some increase in relative demand from abroad. Failing that the necessary currency adjustment becomes much bigger. Ken Rogoff, who is about to Obstfeld, an economist at the university of California at Berkeley reckon it will take a fallon o return to Harvard University after a two-year stint as chief economist at the IMF, and mauric closer to 35% to get the current account back into balance. Mr O'Neill from Goldman Sachs is even more pessimistic, estimating that a trade-weighted drop of 43% will be needed to reduce the current-account deficit by 2% of gDP by 2007. And Mr Rosenberg of Deutsche Bank thinks that if demand patterns stay as they are, a depreciation of 40-50% may be called for to get the current-account deficit down to 3. 5%o of gdp These are enormous shifts. If the burden were spread equally across America's trading partners, a 50% drop in the dollar would send the euro to well over $2 and the yen to less than 60 per dollar. With exchange-rate changes of this magnitude, the risk is that currencies may move too fast and perhaps even too far. Historically exchange rates have tended to overshoot In the 1980s the dollar soared, then plummeted. In Mexico in 1995, the peso plunged and then recovered In the 1997-98 Asian crisis, Indonesia's rupiah dropped by over 75% before gradually creeping back. Even big exchange-rate shifts can be absorbed if they occur slowly. (The 8% drop in the dollar since early 2002, for instance, has not caused any problems. )But if they happen quickly financial markets are roiled and at worst financial institutions are unable to cope with the strain. LTCM, a hedge fund collapsed when interest rates suddenly shifted after Russias default in the summer of 1998. If the dollar suddenly plunged, similar problems could ariseIn the real world, however, matters are more complicated. First, a drop in the exchange rate does not necessarily lead to an equivalent rise in the price of imported goods. This is partly because the final price of an imported good includes numerous costs, such as distribution and marketing, that are not affected by the exchange rate. Second, many countries that export to the United States (especially Asian ones) price their goods in dollars. Since these exporters are usually extremely keen to maintain their share in the world's biggest market, they often absorb the effect of a drop in the dollar by cutting their profits rather than raising the price. Economists reckon that in the 1990s only about half of an exchange-rate change had worked its way through to manufacturing import prices after a year. Over a shorter period the effect can be even less. In the year to May, says Michael Rosenberg, chief currency strategist at Deutsche Bank, import prices to America, excluding oil, rose only 0.9%, even though the trade-weighted dollar fell by 6%. But even if prices do move, spending patterns may remain much the same for a while, because consumers tend to be slow to adjust their spending in response to price changes. It also takes firms time to change orders and production levels. And even in the long run, the impact on imports of a drop in the dollar is weaker than that of a drop in income. According to calculations by Ms Johnson and Messrs Hooper and Marquez, a 1% drop in the dollar reduces Americans' demand for imports by only 0.3% in the long term. A 1% drop in income, on the other hand, reduces imports by 1.8%. So if a drop in the dollar is to make much of a dent in the trade deficit, it will have to be really big. But just how big? The exact estimates differ, depending on how economists construct their models, but virtually all the numbers are startling. In perhaps the most optimistic analysis, Fred Bergsten of the Institute for International Economics reckons that the dollar needs to fall by another 15-20% on a trade-weighted basis to bring America's current-account deficit down to 3% of GDP. His calculation assumes some increase in relative demand from abroad. Failing that, the necessary currency adjustment becomes much bigger. Ken Rogoff, who is about to return to Harvard University after a two-year stint as chief economist at the IMF, and Maurice Obstfeld, an economist at the University of California at Berkeley, reckon it will take a fall of closer to 35% to get the current account back into balance. Mr O'Neill from Goldman Sachs is even more pessimistic, estimating that a trade-weighted drop of 43% will be needed to reduce the current-account deficit by 2% of GDP by 2007. And Mr Rosenberg of Deutsche Bank thinks that if demand patterns stay as they are, a depreciation of 40-50% may be called for to get the current-account deficit down to 3.5% of GDP. These are enormous shifts. If the burden were spread equally across America's trading partners, a 50% drop in the dollar would send the euro to well over $2 and the yen to less than 60 per dollar. With exchange-rate changes of this magnitude, the risk is that currencies may move too fast and perhaps even too far. Historically, exchange rates have tended to overshoot. In the 1980s the dollar soared, then plummeted. In Mexico in 1995, the peso plunged and then recovered. In the 1997-98 Asian crisis, Indonesia's rupiah dropped by over 75% before gradually creeping back. Even big exchange-rate shifts can be absorbed if they occur slowly. (The 8% drop in the dollar since early 2002, for instance, has not caused any problems.) But if they happen quickly, financial markets are roiled, and at worst financial institutions are unable to cope with the strain. LTCM, a hedge fund, collapsed when interest rates suddenly shifted after Russia's default in the summer of 1998. If the dollar suddenly plunged, similar problems could arise