Leading paradigms in international macroeconomics connect the movements of the exchange rate that prevails between trading partners to the changes in their terms of trade. Milton Friedman (1953) famously argued that a flexible exchange rate generates just the ‘right’ changes in a country's import and export prices to keep it at full employment even when prices are sticky in the producer's currency. This insight is also a central prediction of the canonical Mundell-Fleming paradigm (Mundell 1963, Fleming 1962, Obstfeld and Rogoff 1995) which assumes that a nominal exchange rate depreciation is associated with a deterioration of a country's terms of trade (i.e. the ratio of the price of its imports to the price of its exports). In other words, the ratio of the price of its imports to that of its exports increases when the nominal exchange rate depreciates. An opposing influential paradigm (Betts and Devereux 2000, Devereux and Engel 2003) assumes pricing in the local (or destination) currency and has at its core the opposite prediction – a nominal exchange rate depreciation is associated with an improvement of a country's terms of trade. Globally, these paradigms imply that a country's exchange rate is only as important as its share in world trade, with no exchange rate playing a disproportionate role.
Recent evidence reveals that a clear majority of trade is invoiced in a small number of ‘dominant currencies’ with the US dollar playing an outsized role (Goldberg and Tille 2008, Gopinath 2015). Accordingly, Casas et al. (2016) develop a ‘dominant currency paradigm’ where trade prices are sticky in dollars and a country’s exchange rate vis-à-vis the dollar is a primary driver of its trade prices, quantities, and the terms of trade. The evidence they provide using Colombian micro data lends strong support to these predictions.
To gauge the global relevance of the three pricing paradigms, in a new study we construct harmonised annual bilateral import and export unit value and volume indices for a globally representative sample (Boz et al. 2017). Our indices are for 55 countries, yielding more than 2,500 dyads (i.e. trading pairs) from highly disaggregated UN Comtrade data starting as early as 1989, depending on the country, and covering through to 2015. The countries in our sample comprise 91% of the global total good exports and imports in 2015. Importantly, we exclude commodities from these indices because the paradigms are relevant only for goods with sticky prices.
We find that neither the producer nor the local currency pricing paradigm fits the observed patterns in global trade, but the data rather support the dominant currency paradigm. Our data suggest that it is the countries’ exchange rates vis-à-vis the US dollar that largely shape trade prices and quantities. This happens regardless of whether the US is part of the trade transaction. Invoicing of trade in dollars is an important part of the explanation.
Below we elaborate more on four key facts that lead to our conclusions.
1. Terms of trade are insensitive to bilateral exchange rates
We find that a 1% depreciation of the bilateral exchange rate leads to a mere 0.04% depreciation of the bilateral (non-commodities) terms of trade. This impact is precisely estimated to be virtually zero, with a 95% confidence interval of [0.02%, 0.05%]. The finding stands in sharp contrast to the predictions of the leading benchmark paradigms. The Mundell-Fleming paradigm would predict the terms of trade to deteriorate by almost 1%, while local currency pricing would predict an improvement by the same magnitude given fully rigid nominal prices. It is, however, fully consistent with the dominant currency paradigm – with most imports and exports invoiced in dollars, the terms of trade of a country are disconnected from its exchange rate.
2. Changes in the dollar exchange rate dominate changes in the bilateral exchange rates between trading partners in accounting for import price and quantity movements
We next estimate the pass-through of bilateral exchange rates into import prices and volumes at the country pair level. A 1% depreciation in the exchange rate of the importer relative to its trading partner leads to a rise in import prices by 0.76% (Figure 1). This suggests an almost complete pass-through at the one year horizon. However, adding in the exchange rate of the importer relative to the dollar dramatically reduces the impact of the bilateral exchange rate from 0.76% to 0.16%. Instead, the dollar exchange rate becomes the dominant factor with an impact of 0.78% on import prices.
Figure 1 Impulse response of bilateral price level to exchange rates
Note: Figure plots the impulse responses of bilateral price level to bilateral and US dollar exchange rates, estimated using importer reported data. Left column estimates are from a standard specification where bilateral import price changes are regressed on bilateral exchange rate changes. Right column adds the importer versus US dollar exchange rate as an explanatory variable. Error bars show 95% confidence intervals with standard errors clustered by dyad.
Additionally, the role of the dollar fluctuations is larger for countries that invoice more in dollars. Merging our trade data with importer's country-level dollar invoicing share from Gopinath (2015), we find that 10 percentage point increase in the share of a nation’s imports invoiced in dollars is associated with a dollar pass-through increase of 3.5 percentage points. This dollar pass-through figure represents the increase in sensitivity of a nation’s import prices to the dollar’s value.
Similarly, adding the dollar exchange rate to a bilateral volume forecasting regression knocks down the coefficient on the bilateral exchange rate by a substantial amount. The contemporaneous volume elasticity for the dollar exchange rate is -0.19, while the elasticity for the bilateral exchange rate is an order of magnitude smaller at -0.03. We also find that the dollar's role as an invoicing currency is indeed special as it handily beats the explanatory power of the euro in price and volume regressions.
3. The strength of the US dollar is a key predictor of rest-of-world aggregate trade volume and inflation
A 1% US dollar appreciation against all other currencies in the world predicts a 0.6-0.8% decline within a year in the volume of total trade between countries in the rest of the world, controlling for the global business cycle.
Furthermore, countries with larger dollar import invoicing shares experience higher pass-through of the dollar exchange rate into consumer and producer price inflation. While these findings are puzzling from the perspective of the traditional Mundell-Fleming model due to its emphasis on bilateral exchange rates, they emerge naturally under the dominant currency paradigm.
4. The importer's share of imports invoiced in dollars explains about 15% of the variance of dollar pass-through/elasticity across country pairs
We next build a flexible hierarchical Bayesian framework to see what fraction of cross-dyad heterogeneity in pass-through coefficients is explained by the propensity to invoice imports in dollars. Unlike standard panel regressions that can be informative about the average pass-through and the statistical significance of the determinants of pass-through heterogeneity, the Bayesian approach allows us to quantify the overall cross-sectional heterogeneity of exchange rate pass-through/elasticities and the relation of this heterogeneity to dollar invoicing.
We estimate that the importer's dollar invoicing share explains 15% of the overall cross-dyad variance in dollar exchange rate pass-through into prices. We also find that the importer's dollar invoicing share affects the exchange rate elasticity of trade volumes. These findings confirm the quantitative importance of the global currency of invoicing, a key concept in the dominant currency paradigm.
Our findings reveal that the terms of trade are only weakly sensitive to the exchange rate, the value of a country's currency relative to the dollar is a primary driver of a country's import prices and quantities regardless of where the good originates from, and the prevalence of dollar invoicing is an important predictor of the sensitivity of price and quantities to the dollar exchange rate. Given the magnitudes of our estimates and the global coverage of our data, the dominant currency paradigm is a more empirically relevant benchmark than the traditional modelling approaches when analysing the international transmission of shocks, and optimal monetary and exchange rate policy.
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