Dominant Currency Paradigm

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... [ view full abstract ]

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) terms of trade are 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, but mainly driven by the dollar exchange rate; export expansions following depreciations are weak and may fall if depreciations are concentrated against the dollar. Consequently, a strengthening of the

dominant currency relative to non-dominant ones can negatively impact global trade. Using merged firm level and customs data from Colombia we document strong support for the dominant currency paradigm and reject the alternatives of producer currency and local currency pricing.