Exchange-Rates | Macro Paper Warehouse

Dollar Dominance and the Transmission of Monetary Policy

Mon, 01 Jan 0001 00:00:00 +0000

Layer 1 — Summary

An emerging view in international macroeconomics contends that dollar invoicing of exports renders monetary policy ineffective for non-U.S. countries: because export prices are allegedly sticky in dollars, exchange rate depreciations cannot shift expenditure toward domestic goods, muting the classical Mundell-Fleming channel. McLeay and Tenreyro argue that this view rests on empirical assumptions that are not borne out by the data: goods priced in dollars tend to have more flexible prices and higher elasticities of substitution, not the monopoly power and sticky dollar prices assumed in dominant currency pricing (DCP) models. They propose a mixed currency pricing (MCP) framework that incorporates heterogeneous price flexibility and intra-sector international competition, and show that even with dollar pricing, depreciating the currency by loosening monetary policy can still boost exports and activity materially. The limit to any expansion is not demand, but supply capacity: after a depreciation, domestic dollar costs fall, flexible-price exporters lower prices slightly and gain large market share due to high demand elasticities, and the expansion runs until rising marginal costs offset the initial depreciation — producing limited reduced-form dollar pass-through as an equilibrium result rather than evidence of nominal stickiness. Empirical tests using monetary policy shocks in a sample of emerging and developing economies, case studies of Canada and Chile as commodity exporters, and three large devaluation episodes all find significant, material increases in exports and aggregate activity following exchange-rate depreciations, consistent with the MCP model’s predictions.

In depth

Q1. What is the specific empirical claim that DCP models rest on, and how do McLeay and Tenreyro challenge it?

DCP models (e.g., Gopinath et al. 2020) posit that exporters invoicing in dollars have monopoly power and face nominal rigidities that keep their dollar export prices sticky. The observable implication used to motivate this assumption was limited exchange rate pass-through to dollar export prices. McLeay and Tenreyro show that low pass-through is equally consistent with a flexible-price, high-elasticity equilibrium. When demand elasticities are high, firms optimally absorb exchange rate changes through quantities rather than prices; the reduced-form pass-through coefficient is small even without any nominal friction. Low pass-through is therefore not informative about the degree of nominal rigidities, and using it to calibrate sticky-price DCP models and draw normative conclusions about exchange rate policy is unwarranted.

Q2. What are the three empirical facts that motivate the MCP framework’s assumptions?

Fact 1: Homogeneous products (commodities and commodity-like goods traded on organized exchanges or reference-priced, following Rauch 1999) represent a large share of goods exports, exceeding 70% for developing economies, around 60% for emerging economies, and around 35% for advanced economies; Sub-Saharan Africa, Latin America, and the Middle East all have shares above 50%. Fact 2: Homogeneous and more competitively produced goods have more flexible prices, documented across multiple countries — for instance, Nakamura and Steinsson (2008) find a median monthly price-change frequency of 10.8% for finished-good producer prices but 98.9% for crude materials. Fact 3: Dollar (vehicle currency) invoicing is most prevalent precisely in these homogeneous, competitive-good sectors; classical work by McKinnon (1979) and Magee and Rao (1980) emphasized that vehicle-currency invoicing facilitates continuous price comparability in competitive markets, and panel regressions corroborate a positive relationship between the share of exports invoiced in dollars and the homogeneous-goods share of exports.

Q3. What is the mechanism through which depreciation boosts exports in the MCP model, and why does this generate low observed pass-through?

With sticky wages (representing non-tradable input price stickiness more broadly), a monetary policy-induced depreciation lowers the domestic cost of production when expressed in dollars. For competitive exporters facing highly elastic demand, even a small reduction in the dollar price translates into a substantial gain in export quantities. Firms therefore lower their dollar prices slightly, trading some profit margin for a large increase in market share. As exports expand, domestic marginal costs rise (firms move up the upward-sloping marginal cost curve), partially offsetting the depreciation’s effect on dollar costs. In equilibrium, the net dollar price movement is small — producing the observed limited pass-through — but the quantity response is large. In the perfectly competitive limit (relevant for commodity exporters), the dollar price is unchanged by the world market, and the entire adjustment is through an expansion of export volumes until rising domestic marginal costs absorb the depreciation. The implied observation is identical to a sticky-price model for prices, but “the implications for export quantities are diametrically opposed.”

Q4. How does the MCP model nest existing frameworks, and what does it add relative to the DCP and PCP benchmarks?

The MCP (mixed currency pricing) framework nests sticky-price DCP as a special case (by setting demand elasticities low and allowing full price stickiness) and produces behavior close to PCP (producer currency pricing) in the flexible-price, high-elasticity limit — restoring the allocative properties of the exchange rate from Obstfeld and Rogoff (1995). The distinctive addition is intra-sector international competition: domestic exporters face competition from international competitors producing highly substitutable varieties of the same good, so substitution elasticities can be high at the variety level even when macro-level elasticities between goods remain low. This follows a bottom-up approach to elasticities as in Feenstra et al. (2018). The model also allows heterogeneous nominal rigidities across producers, with exporters of dollar-invoiced homogeneous goods having flexible prices while non-tradable input prices (wages) remain sticky — the source of monetary non-neutrality and the mechanism for real exchange rate effects.

Q5. What is the role of supply capacity, and why is it “the limit” rather than demand?

In the sticky-price DCP model, the constraint on the export response is on the demand side: dollar prices do not move, so demand is unchanged, and there is no export response at all. In the MCP model, demand responds immediately to the cost reduction — the constraint that eventually stops the expansion is supply capacity, captured by the slope of the marginal cost curve and macroeconomic constraints on non-tradable inputs. With a flat marginal cost curve (plentiful supply capacity), exports expand materially; with a steep curve or hard capacity constraints, the increase in marginal cost fully offsets the depreciation before much quantity adjustment occurs. This supply-side framing reorients the policy question: the limiting factor for monetary policy’s external effectiveness is not whether dollar prices can move, but whether the domestic economy has the productive capacity to expand tradable output. This also connects the paper to the Salter-Swan two-good framework and to Schmitt-Grohé and Uribe (2021).

Q6. What do the macroeconomic empirical tests find, and how do they distinguish the MCP from sticky-price DCP?

The paper uses three empirical exercises. First, using a sample of developing and emerging economies, monetary policy expansions that generate exchange rate depreciations cause significant increases in both exports and aggregate economic activity — consistent with the MCP model’s material export response and inconsistent with the DCP prediction of no export channel. Second, focusing on Canada and Chile as commodity exporters where the MCP assumptions (competitive markets, flexible export prices) are especially applicable, the aggregate results are corroborated and sectoral evidence provides additional support. Third, three case studies of large devaluations in the sample document that they are followed by material increases in exports relative to trend. In all exercises, the direction and magnitude of export and output responses are consistent with a functioning expenditure-switching channel, even where exports are priced in dollars.

Q7. How does the paper reinterpret the pass-through evidence that motivated sticky-price DCP models, and what does this imply for normative conclusions?

Standard reduced-form pass-through regressions relate the change in dollar export prices to changes in the exchange rate. These regressions typically omit or fail to fully capture movements in marginal cost. In the MCP model, flexible-price firms fully pass through changes in marginal cost; the observed limited pass-through to export prices is an equilibrium result of the offsetting rise in marginal costs as export volumes expand, not evidence of a nominal friction. Because the standard regressions omit marginal cost dynamics, they risk attributing the equilibrium quantity-driven equilibrium to a pricing friction. This has direct normative implications: the case made by the IMF (2019, 2020) that dollar invoicing worsens the cost-benefit calculation for flexible exchange rates — and may bolster the case for capital controls — rests on interpreting low pass-through as evidence of stickiness. If low pass-through instead reflects high demand elasticities and supply-side adjustment, the normative argument for constraining exchange rate flexibility is weakened.

Q8. How does the paper relate to the purchasing power parity puzzle and the Mussa puzzle?

The MCP framework offers explanations for two classic international macro puzzles without assuming nominal rigidities in export prices. On the PPP puzzle (the volatility and persistence of the real exchange rate, Rogoff 1996): in the MCP model, exporters’ optimal reset prices move very little after exchange rate changes — not because of stickiness, but because demand is elastic and marginal costs rise quickly. This predicts limited movement in relative export prices, consistent with empirical evidence in Blanco and Cravino (2020) and Itskhoki and Mukhin (2025). On the Mussa puzzle (the large jump in nominal and real exchange rate volatility after the Bretton Woods collapse): the model’s mechanism via sticky wages is consistent with evidence that depreciations produce slow adjustment of non-tradable prices (Burstein, Eichenbaum, and Rebelo 2005), generating real exchange rate movements despite limited response in traded-good dollar prices.

Key Concepts

Dominant currency pricing (DCP): A framework in which non-U.S. exporters set and maintain prices in U.S. dollars, with sticky dollar prices. As formulated by Gopinath et al. (2020), DCP predicts that exchange rate depreciations by non-U.S. countries do not reduce dollar export prices and therefore do not stimulate export demand — muting the expenditure-switching channel of monetary policy.

Mixed currency pricing (MCP): The framework introduced in this paper. It allows heterogeneous price flexibility and market structure across export sectors, nesting both sticky-price DCP and flexible-price PCP as special cases. Dollar-priced exports face elastic demand from international competition, have flexible prices, and respond to depreciations through quantities rather than prices. Non-traded inputs (wages) remain sticky, providing the source of monetary non-neutrality.

Expenditure-switching channel: The mechanism by which exchange rate depreciations redirect spending toward domestically produced goods, boosting exports and aggregate demand. In PCP models, this works through a fall in relative export prices. In the MCP model, it works through an expansion in export quantities even when dollar prices change little.

Exchange rate pass-through (to export prices): The elasticity of dollar export prices with respect to the nominal exchange rate. In sticky-price DCP models, low pass-through reflects a nominal friction (prices cannot adjust). In the MCP model, low pass-through reflects high demand elasticities and offsetting marginal cost increases: it is an equilibrium outcome, not a friction, and therefore does not imply that export volumes are unresponsive.

Intra-sector international competition: The market structure feature central to the MCP framework. Domestic exporters of a given good compete with foreign suppliers of highly substitutable varieties, making their demand elastic at the variety level even if aggregate elasticities across different goods categories are low. This follows Armington (1969) as implemented by Feenstra et al. (2018).

Supply capacity constraint: In the MCP model, the binding constraint on how much a depreciation can boost exports. With high demand elasticities, demand for domestic exports expands freely; the limit is set by how quickly rising domestic marginal costs absorb the improvement in export profitability. The supply constraint replaces the demand constraint that operates (mechanically, via zero price response) in sticky-price DCP models.

Homogeneous goods (Rauch 1999 classification): Goods traded on organized commodity exchanges or reference-priced in trade publications, as opposed to differentiated goods. McLeay and Tenreyro use this classification to establish that dollar-invoiced exports are disproportionately homogeneous, competitive, and flexible-priced — contrary to the DCP assumption of monopoly power and price stickiness.

Summary based on published open-access version. AI-assisted, human review pending.

Sanctions and the Exchange Rate

Mon, 01 Jan 0001 00:00:00 +0000

Layer 1 — Core Argument

Itskhoki and Mukhin develop a tractable open-economy model with financial market segmentation — in which only the government sector (including state banks and exporting firms) can intermediate cross-border capital flows — to study how trade and financial sanctions affect the nominal exchange rate. Their first main result is a Lerner-symmetry equivalence: sanctions limiting a country’s exports or freezing its foreign assets depreciate the exchange rate, while sanctions limiting imports appreciate it, even though both types of policies have exactly the same effect on real allocations, including household welfare and government fiscal revenues. The mechanism is direct — export sanctions reduce the supply of foreign currency, requiring depreciation to restore market clearing, whereas import sanctions reduce the demand for foreign currency, requiring appreciation — and because real income effects are identical, the exchange rate movement is not informative about effectiveness: one cannot evaluate the effectiveness of sanctions based solely on the dynamics of the exchange rate. Beyond direct trade sanctions, increased precautionary savings in foreign currency also depreciate the exchange rate when they are not offset by the sale of official reserves or financial repression of foreign-currency savings. Applying the calibrated model to Russia’s post-invasion experience, the dynamics of the ruble exchange rate following Russia’s invasion of Ukraine in February 2022 are quantitatively consistent with the combined effects of these forces calibrated to the observed sanctions and government policies; the combined effect from 2.5 years of sanctions corresponds to a permanent decline in consumption of 0.9% in Russia, while the net effect is close to zero for the rest of the world, and the freeze of FX reserves together with import tariffs act as a positive transfer from Russia to the rest of the world while quantity restrictions on exports raise world energy prices and generate global welfare losses.

In depth

Q1. Q: What is the core theoretical result on trade sanctions and the exchange rate?

A: Proposition 1 establishes that permanent sanctions on imports (raising import prices P*_t by τ) are equivalent in their effect on import consumption and welfare to a combination of permanent sanctions on exports (reducing export prices Q*_t by τ) and a partial seizure of foreign assets (reducing F*_0 by τ). Both sets of sanctions produce the same path of reduced import quantities and the same welfare loss. However, sanctions on exports cum foreign-asset seizure are associated with an additional depreciation of the exchange rate by τ percent relative to import sanctions. This equivalence is a manifestation of Lerner (1936) symmetry extended to a dynamic international macro environment.

Q2. Q: What is the intuition for the opposite exchange rate movements under import versus export sanctions?

A: Both kinds of sanctions shrink the country’s feasible import consumption set equivalently in real terms, but they operate through different channels. Export sanctions directly reduce the inflow of foreign currency (export revenues fall), so the exchange rate must depreciate to discourage import demand and bring it in line with the reduced budget. Import sanctions raise the price of foreign goods directly; without an offsetting movement, this would create excess demand for domestic non-tradables. To eliminate the excess demand and leave export revenues partially used, the exchange rate must appreciate. In both cases, the import demand schedule — CF_t = (E_t P*_t / P_t)^{-θ} γ Y_t — pins down the exchange rate that supports the same equilibrium import allocation.

Q3. Q: Does fiscal equivalence also hold, even when the government relies primarily on exports for revenue?

A: Yes. Proposition 1 and the surrounding analysis show that the equivalence result for export and import sanctions extends to the fiscal balance, even when the government relies exclusively on exports for fiscal revenues. The mechanism is a general equilibrium adjustment in the exchange rate: depreciation (under export sanctions) partially ameliorates the impact by increasing the local-currency purchasing power of export revenues, while appreciation (under import sanctions) has the opposite effect. The net fiscal-balance effect of both kinds of sanctions ends up being the same.

Q4. Q: What role does the financial market segmentation assumption play?

A: The paper assumes a form of financial market segmentation in which only the government sector (including state banks and exporting companies) can intermediate capital flows across the border, subject to international restrictions. This captures both the withdrawal of foreign investors from the Russian market and the segmentation of Russian households from the international financial market due to external sanctions and domestic capital controls. Under this structure, exports and FX reserves are the key sources of currency supply to the economy, and imports plus domestic foreign-currency savings are the key sources of currency demand; the equilibrium exchange rate is determined by the balance of these in the domestic market. Ricardian equivalence for foreign-currency savings does not hold when κ > 0 in the household utility function, so government reserve policy has real effects.

Q5. Q: What is the role of precautionary savings demand for foreign currency?

A: Households have foreign-currency bonds in their utility function reflecting a precautionary (hedging) demand for future purchases of foreign tradables, parameterized by a shock Ψ_t. When financial conditions collapse — the local stock market crashes, domestic deposits face inflation and bank-run risk, and access to foreign assets is constrained — Ψ_t rises above the real value of household FX savings, creating pressure to accumulate foreign-currency savings despite low expected returns. With inelastic inflow of foreign currency from exports (due to financial sanctions) and no feasible FX reserve sale, a large jump-depreciation is required to restore equilibrium by curbing the increased demand for foreign currency via lower expected returns and higher import prices. The effect is transitory: it dies out as households accumulate enough FX savings. The optimal government response is to sell FX reserves to accommodate household demand without an exchange rate devaluation.

Q6. Q: What happens when FX interventions are infeasible?

A: When the central bank’s reserves are frozen by sanctions or otherwise unavailable, the government can use financial repression to offset the exchange rate effects of financial shocks. Specifically, by imposing fees on purchasing and withdrawing foreign currency — thereby reducing the household return on foreign-currency deposits R*_H below the international rate R*_t — the central bank can suppress foreign-currency demand. While financial repression is suboptimal in a representative-agent economy, it may be second-best in heterogeneous-agent economies or economies with balance-sheet effects. Importantly, the exchange rate remains allocative even under financial sanctions and financial repression; it is not rendered irrelevant by these policies.

Q7. Q: How do the results change when Russia is modeled as a large economy in the commodity market?

A: Section 3 extends the analysis to an economy that is large in the world commodity market, modeling Russia as a large commodity exporter, and spelling out specific policy instruments. The paper shows that import prices and export revenues still constitute a sufficient statistic for the macroeconomic effects on the economy under sanctions. However, the welfare implications for the rest of the world depend crucially on whether sanctions take the form of trade taxes or quantity restrictions. A price cap on exported commodities can replicate a tax on exports, achieving the desired wealth transfer to the coalition. In contrast, imposing quantity restrictions on a large commodity exporter reduces global supply and drives up world energy prices, hurting the sanctioned economy when it lowers export revenues, but also imposing substantial costs on senders.

Q8. Q: How does the paper calibrate the model to Russia’s ruble dynamics, and how well does it fit?

A: The paper employs two calibration strategies. The first reproduces the ex-ante calibration from the 2022 working paper version based on scant data available in the first months after the invasion, without targeting any exchange rate moments. This calibration provides a remarkable out-of-sample fit, predicting accurately the dynamics of the ruble in the following two years. The second is an ex-post calibration that infers structural shocks to perfectly match observed dynamics of Russian imports, exports, commodity prices, domestic output, official FX reserves, inflation, and the exchange rate. Both approaches agree on the decomposition of exchange rate dynamics and confirm the quantitative importance of the theoretical mechanisms.

Q9. Q: What does the calibrated decomposition say about the phases of ruble dynamics?

A: The initial sharp depreciation in the first weeks after the invasion is mostly driven by increased precautionary demand for foreign currency. The frozen FX assets translate into modest losses of permanent income (only about 3% depreciation), but the asset freeze and sanctions on the Central Bank had a much larger indirect effect by limiting the capacity to accommodate the financial shock with FX interventions. One month out, trade shocks begin to dominate: import restrictions curb FX demand, while the spike in energy prices elevated Russian export revenues, increasing foreign-currency inflows. These forces combined neutralize capital outflows and the surge in financial FX demand, explaining the sharp appreciation of the ruble by summer 2022 (about 30% stronger than pre-war by June). Over time, import quantities recovered as parallel imports and new trade linkages were established, and export revenue inflows contracted as commodity prices declined, bringing the exchange rate back to and then about 20% weaker than pre-war levels.

Q10. Q: What are the welfare and fiscal consequences quantified by the calibrated model?

A: The initial exchange rate depreciation boosted fiscal revenues by 12%, amplified further by greater export revenues starting in the second month. These effects were offset in the medium run by the exchange rate appreciation due to trade sanctions, with net real income turning negative starting from April 2022. International sanctions decrease long-run real government revenues by about 4%, mostly due to a reduction in export revenues. The combined effect from 2.5 years of sanctions corresponds to a permanent decline in consumption of 0.9% in Russia — vastly larger than conventional estimates of the cost of a business cycle — and close to zero on net for the rest of the world. Consistent with the theoretical results, the freeze of FX reserves and import tariffs act as a positive transfer from Russia to the rest of the world, while quantity restrictions on exports result in higher energy prices, lower consumption, and global welfare losses.

Q11. Q: Why cannot the exchange rate be used to evaluate the effectiveness of sanctions in real time?

A: Because import sanctions and export sanctions generate opposite exchange rate movements while having exactly the same effect on real allocations, welfare, and fiscal balance, there is no one-to-one mapping between the exchange rate and welfare under sanctions. A strong exchange rate (appreciation) after sanctions may reflect import restrictions — which are just as effective in reducing real income as export restrictions that would have caused depreciation. Conversely, a weak exchange rate need not imply sanctions are ineffective; it may simply reflect that sanctions took the form of export or asset-freeze measures. The ruble’s rapid appreciation through summer 2022 illustrates this: rather than indicating that sanctions failed, it was largely consistent with the combination of import restrictions and high commodity prices, while the underlying real income effect was substantially negative.

Key Concepts

Lerner symmetry (macroeconomic version): The principle, originating in Lerner (1936), that a uniform import tariff and a uniform export tax yield the same real economic outcomes — the same allocation and welfare — but are sustained by a differential movement in relative prices (appreciation versus depreciation). In the paper’s context, both import and export sanctions of equivalent magnitude reduce the real income of the sanctioned economy by the same amount and produce the same path of import consumption and welfare, even though they move the exchange rate in opposite directions.

Financial market segmentation: The model’s departure from standard international macro in which only the government sector (including state banks and exporting companies) can intermediate cross-border capital flows, subject to international restrictions. Households cannot freely access international financial markets. This makes exports and FX reserves the only sources of foreign-currency supply to the domestic economy, and imports plus domestic foreign-currency savings the only sources of demand, so the exchange rate is determined entirely by the domestic balance of these flows.

Precautionary foreign-currency demand shock (Ψ_t): A shock that raises the household bliss-point for real foreign-currency bond holdings above the current stock, capturing a collapse in the supply of alternative savings vehicles (domestic stocks, bank deposits, access to foreign assets). In the model it enters households’ utility directly; an increase in Ψ_t above real FX savings creates depreciatory pressure on the exchange rate when not offset by FX reserve sales or financial repression.

Financial repression (in the model): Government suppression of the household rate of return on foreign-currency deposits R*_H below the international rate R*_t, implemented via fees on purchasing and withdrawing foreign currency. It offsets the depreciatory effect of a precautionary savings shock without requiring FX reserve sales, at the cost of a distortion in the domestic financial market. The paper notes Russia introduced such fees in March–April 2022.

Sufficient statistic for macroeconomic effects: When the sanctioned economy is large (as Russia is in global energy markets), import prices and export revenues still constitute a sufficient statistic for the macroeconomic effects of sanctions on the economy — i.e., the same pair of variables summarizes welfare, fiscal, and exchange rate outcomes regardless of the specific instrument used to impose sanctions, provided the terms of trade deterioration is the same.

Price cap (as an export tax equivalent): A price cap on a sanctioned country’s exported commodities can replicate the effect of a tax on exports from the coalition’s perspective, achieving the same real-income transfer from the sanctioned country to the rest of the world without reducing global supply (as quantity restrictions do). This distinguishes it from quantity restrictions on exports, which reduce global energy supply and impose welfare costs on the coalition.

Summary based on LSE Research Online accepted version. AI-assisted, human review pending.