Camila Casas, Mr. Federico J Diez, Ms. Gita Gopinath, and Pierre-Olivier Gourinchas
Most trade is invoiced in very few currencies. Despite this, the Mundell-Fleming benchmark
and its variants focus on pricing in the producer’s currency or in local currency. We
model instead a ‘dominant currency paradigm’ for small open economies characterized by
three features: pricing in a dominant currency; pricing complementarities, and imported input
use in production. Under this paradigm: (a) the terms-of-trade is stable; (b) dominant currency
exchange rate pass-through into export and import prices is high regardless of destination or
origin of goods; (c) exchange rate pass-through of non-dominant currencies
is small; (d) expenditure switching occurs mostly via imports, driven by the dollar exchange
rate while exports respond weakly, if at all; (e) strengthening of the dominant currency
relative to non-dominant ones can negatively impact global trade; (f) optimal monetary policy
targets deviations from the law of one price arising from dominant currency fluctuations,
in addition to the inflation and output gap. Using data from Colombia we document strong
support for the dominant currency paradigm.
and nontraded goods in domestic currency is referred to as the real exchange rate; an appreciation of the local-currency exchange rate results in an equivalent decrease in the domestic-currencypriceofexports. Also, see Kalter (1978) where, even where the world price is not given, exchange rate changes are not fully passed through to the foreign-currencypriceofexports. Thus, nominal exchange rate appreciation (not fully passed through to an increase in the foreign-currency export price) results in a decreased domestic-currency export price and, thus, a fall
elastic at the given world price), the exchange rate depreciation does not change export prices measured in foreign currency (e.g., the U.S. dollar) terms, but may induce a positive supply response by raising the domestic currencypriceofexports relative to non-traded goods. Since dollar prices remain constant, and volumes increase, the foreign currency value of exports should rise as well.
7. By contrast, for countries that predominantly export manufactures (or other differentiated products whose demand is likely to be downward sloping), the nominal exchange rate
This equation suggests that the response of the trade balance to changes in the exchange rate (i.e. the sign of ∂(TB / GDP)/∂E ) depends on the structure of a country’s exports. It is typically assumed that exporters of manufactured goods face a downward sloping demand curve in foreign markets. It follows that a real depreciation will produce a fall in the export price (foreign currency terms), thereby facilitating an increase in market share while simultaneously eliciting no change in the local currencypriceofexports, ∂p x
the difference between total government revenue (T) [consisting of taxes on income and profits(Ti), taxes on goods and services (Tg), taxes on imports (Tm), and stabilization revenue (Ts)], and the sum of current expenditure (Cg), investment expenditure (Ig), and interest on foreign public debt (INTg):
DEF = (Ti + Tg + Tm + Ts) - (Cg + Ig + INTg)
Stabilization revenue (Ts) for exports 1 is equal to the price differential per unit of exports, times the volume of exports 1 (VX). The price differential is equal to the local currencypriceofexports (P1x), minus
The analysis in this paper suggests that import and export volume elasticities are markedly lower in oil-exporting Middle East and Central Asian countries than in non-oil countries in the region. A key implication of this finding is that a real appreciation of the exchange rate in oil-exporting countries would achieve little in terms of expenditure switching: an appreciation does not boost imports and non-oil exports constitute only a small share of GDP and total trade in these countries. Therefore, while a real appreciation lowers the current account surplus of oil-exporting countries through valuation effects, the contribution to lowering global imbalances may be more limited.
The paper finds that simple econometric specifications yield surprising rich and complex dynamics -- relative prices respond to the nominal exchange rate and pass-through effects, import and export volumes respond to relative price changes, and the trade balance responds to changes in import and export values.
performance criteria although these would be formulated in terms of ceilings/floors rather than targets.
15 Note the difference between the underlying inflation and the change in the GDP deflator. The underlying inflation is based on the price index for output supplied domestically while the GDP deflator also depends on prices for exports and imports. This implies that the underlying inflation is less responsive to discrete changes in domestic currencypricesofexports and imports compared to the GDP deflator.
16 Although the rate of inflation is included to