04 October 2019

ECB: Working paper: Introducing dominant currency pricing in the ECB’s global macroeconomic model

In this paper, authors document the introduction of DCP into ECB-Global, the ECB’s main global macroeconomic model. To the best of author‘s knowledge, this is the first attempt of introducing DCP into a major global macroeconomic model used at policy institutions.

Academic research has recently highlighted the role of dominant-currency pricing (DCP) for the domestic and cross-border transmission of shocks. Traditionally, open economy models assume that exports are priced and invoiced in the currency of the producer, i.e. producer-currency pricing (PCP), or in the currency of the destination, i.e. local-currency pricing (LCP). 

In contrast, the data suggest that a large share of trade is invoiced in a few dominant currencies. In particular, the data document that a large share of global trade is invoiced in US dollar. This is the case in particular for emerging market economies (EMEs), and notably for transactions that do not involve the US as a trading partner.

DCP has important implications for the dynamics of trade variables that differ from those under PCP and LCP. For example, in case of a multilateral appreciation of the Home currency driven by a contractionary monetary policy shock, Home terms-of-trade are stable as import and export prices both fall in Home currency terms. This is in contrast to PCP, under which the termsof-trade rise as Home import prices fall while Home export prices are constant; and this is also in contrast to LCP, under which the terms-of-trade fall, as Home import prices in domestic currency are constant while Home export prices in domestic currency fall.

In turn, the differential responses of the terms-of-trade imply differences in the role of expenditure switching in case of a multilateral appreciation of the Home currency driven by a contractionary monetary policy shock.

Specifically, under DCP expenditure switching occurs through imports alone. In contrast, under PCP expenditure switching occurs through both imports and exports, and under LCP expenditure switching is muted overall.

Moreover, under DCP the US dollar is the major driver of global trade, in contrast to the cases of PCP and LCP. Specifically, a multilateral appreciation of the US dollar reduces imports — and thereby exports — globally, even for transactions that do not involve the US as a trading partner.

Authors document that while introducing DCP into ECB-Global does not imply economically significant changes in the dynamics of domestic macroeconomic and financial variables in response to standard shocks, it does imply important changes in the dynamics of imports and exports, the role of expenditure switching and the US dollar exchange rate therein.

Finally, in order to illustrate the usefulness of ECB-Global and DCP for policy analysis, they explore the implications of the Euro rivaling the US dollar as a second dominant currency in global trade. Authors document that according to ECB-Global, in such a shared DCP scenario the global spillovers from US shocks are smaller, while those from euro area shocks are amplified.  In contrast, domestic euro area monetary policy effectiveness is hardly affected by the Euro becoming a second globally dominant currency in trade.

Full working paper on ECB

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