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.
rates, as reflected in elevated term premia.
Source: Staff calculations.
Finally, the modest explanatory power of medium-term inflation expectations for interest rates post-GFC for all G7 countries contrast with predictions made under the fiscal theory of the price level, which links concerns over future inflationtotheratio of public debt. The evidence also implies that the real impact of a change in fiscal policy post-crisis is not likely to have been transmitted through the expected inflation channel. 19
A few caveats are worth noting. First, it is
This paper uses a dataset on private-sector risk aversion as well as expectations of long-run
growth and debt to explain trends in implied forward rates on government bonds in the G-7
countries. The results show, consistent with the literature, that a one-percent rise in the long-run
projected debt-to-GDP ratio causes an increase in bond yields of a relatively modest 1-to-6 basis
points. Shocks to growth expectations and risk aversion have been comparatively more
successful in explaining the behavior of long-term rates. The findings imply that growth policies
rather than long-run projections of fiscal outcomes may be more important in helping influence
long-term borrowing costs.
Camila Casas, Federico J. Díez, Ms. Gita Gopinath, Pierre-Olivier Gourinchas, and Mr. Maurice Obstfeld
price inflation. Strategic complementarities, Г > 0, dampen the impact of movements in real marginal cost or markups on export price inflation. At the same time a higher Г raises the sensitivity of export price inflationtotheratio of export prices to the destination price index (expressed in the same currency) since firms pay more attention to the price of their competitors. A similar interpretation applies to the source/currency specific import price index inflation rate π i H , t j in equ. (25) .
Because marginal costs rely on imported inputs, cost-shocks in