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Dominant Currency Paradigm: A New Model for Small Open Economies
Author:
Camila Casas null

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Mr. Federico J Diez
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Ms. Gita Gopinath
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Pierre-Olivier Gourinchas null

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Series:
IMF Working Papers
Volume/Issue:
Volume 2017: Issue 264
Language:
English
Publication Date:
22 Nov 2017
DOI:
https://doi.org/10.5089/9781484330173.001
ISBN:
9781484330173
ISSN:
1018-5941
Pages:
62
Keywords:
WP; exchange rate; open economy; dollar exchange rate; currency price; currency pricing; destination currency; dollar pricing; production function; inflation to the ratio; currency price of export; misalignment term; inflation rate; peso price; Currencies; Exchange rates; Export prices; Exports; Import prices; Global
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IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
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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.
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Cover IMF Working Papers
IMF Working Papers
ISSN:
1018-5941
Publisher:
International Monetary Fund