Dominant Currency Paradigm

Standard open-economy macro models assume that export prices are sticky either in the producer’s currency, in which case a depreciation improves the terms of trade and competitiveness, or in the destination’s currency, in which case it worsens them. Neither matches the invoicing evidence: the vast majority of world trade is priced in a small number of dominant currencies, with the dollar playing an outsized role. This paper builds an alternative “dominant currency paradigm” from three joint ingredients – infrequently adjusted prices set in a dominant currency, strategic complementarities in pricing that make desired markups variable, and roundabout production using imported inputs – and derives four sharp testable implications: the bilateral terms of trade should be insensitive to bilateral exchange rates; for non-US countries import price pass-through should be high but driven by the dollar rather than the bilateral exchange rate, and more so the higher the country’s dollar invoicing share; import quantities should likewise be driven by the dollar rate, with US import quantities much less responsive; and a uniform appreciation of the dollar should reduce trade among countries other than the United States. The tests use two new datasets: bilateral non-commodity price and volume indices built from UN Comtrade for more than 2,500 country pairs covering 91 percent of world trade, 1992-2015, and firm-10-digit-product-country-quarter customs records for Colombia, an economy that invoices 98 percent of its exports in dollars. All four implications hold. Regressing bilateral terms of trade growth on bilateral exchange rate growth gives a contemporaneous coefficient of 0.037 with a 95 percent confidence interval of [0.02, 0.05], against a predicted 1 under producer currency pricing and −1 under local currency pricing, and the coefficient shrinks further toward zero once relative producer prices are controlled for. A standard bilateral pass-through regression implies near-complete pass-through – a 10 percent depreciation of the importer’s currency against the exporter’s raises import prices about 8 percent within the year – but adding the dollar exchange rate and time fixed effects knocks the bilateral coefficient from 0.76 to 0.16, with the dollar coefficient at 0.78 absorbing almost all of it, and raising a country’s dollar invoicing share by 10 percentage points raises contemporaneous dollar pass-through by 3.5 to 7.6 percentage points. On volumes the contemporaneous dollar elasticity is roughly −0.19 to −0.13 while the bilateral elasticity is an order of magnitude smaller; the euro is far less important than the dollar in both sets of regressions. Consistent with 97 percent of US exports and 93 percent of US imports being dollar-invoiced, bilateral pass-through into US export prices is complete on impact and close to zero for US import prices, and US import volumes are essentially unresponsive to the bilateral exchange rate (an implied 0.003 percent contemporaneous response to a 1 percent dollar depreciation, against −0.12 percent for non-US importers), so US trade balance adjustment runs through exports rather than imports. Aggregating the bilateral panel, a 1 percent ceteris paribus dollar appreciation against all other currencies predicts a 0.6 percent contraction in rest-of-world trade volume within the year, persisting for at least two years, controlling for proxies for the global business and financial cycles; dollar pass-through into foreign CPI and PPI averages 11 and 28 percent within the year and rises with the dollar invoicing share. The Colombian microdata reproduce all of this and additionally let the authors estimate the model: the estimated invoicing shares are essentially DCP, the estimated model tracks the observed dynamics of pass-through while PCP and LCP counterfactuals do not, and removing strategic complementarities and imported inputs halves four-quarter export pass-through from 65 to 30 percent. The authors are explicit about interpretation: the volume regressions “do not capture structural demand elasticity parameters” and “conflate expenditure switching and shifts in aggregate import demand,” so they are predictive relationships rather than structural estimates; and the invoicing currency is taken as given, with the argument that the model’s own ingredients are the ones that would generate dominant-currency pricing endogenously.

Camila Casas | Macro Paper Warehouse

Dominant Currency Paradigm