The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
Camila Casas, Federico Diez, Gita Gopinath, and Pierre-Olivier Gourinchas
INTERNATIONAL MONETARY FUND
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.