Dominant Currency Paradigm: A New Model for Small Open Economies

By Camila Casas, Federico J Diez, Gita Gopinath, Pierre-Olivier Gourinchas

November 22, 2017

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Camila Casas, Federico J Diez, Gita Gopinath, and Pierre-Olivier Gourinchas. Dominant Currency Paradigm: A New Model for Small Open Economies, (USA: International Monetary Fund, 2017) accessed November 23, 2024

Disclaimer: 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.

Summary

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.

Subject: Currencies, Exchange rates, Export prices, Exports, Foreign exchange, Import prices, International trade, Money, Prices

Keywords: Currencies, Currency price, Currency price of export, Currency pricing, Destination currency, Dollar exchange rate, Dollar pricing, Exchange rate, Exchange rates, Export prices, Exports, Global, Import prices, Inflation rate, Inflation to the ratio, Misalignment term, Open economy, Peso price, Production function, WP

Publication Details

Pages:

62
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2017/264
Stock No:

WPIEA2017264
ISBN:

9781484330173
ISSN:

1018-5941

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