This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. In mid-2008, the real effective exchange rate of the dollar was close to its minimum level for the past 4 decades. At the same time, however, the U.S. trade and current account deficits remain large and, absent a significant correction in coming years, would contribute to a further accumulation of U.S. external liabilities. The paper discusses the tension between these two aspects of the dollar assessment, and what factors can help reconcile them. It focuses in particular on the terms of trade, adjustment lags, and measurement issues related to both the real effective exchange rate and the current account balance.

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Material presented in this paper was originally prepared in October 2001 as background for IMF Executive Board discussions on France, Germany, Italy, and Spain. Subsequently, the paper was updated to reflect developments through March 2003. Many colleagues in the Fund contributed, including in the European I, Fiscal Affairs, Asia and Pacific, and Western Hemisphere departments. The help and encouragement of C. Maxwell Watson have been essential to the development and execution of the project. The authors are also particularly grateful for helpful comments and discussions with