In their article, Gopinath et al. (2020) found evidence that global trade volumes and prices are significantly driven by the value of the US dollar, the world’s dominant currency. US domestic policies that increase the value of the dollar against other currencies reduce global trade flows since goods become more expensive in dollar terms and US rest of the world imports do not sufficiently increase.
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Traditional determinants of international trade flows
The traditional, neo-Keynesian models of international trade argue that when country X’s currency depreciates versus another country Y’s it will export more to country Y. This will occur because country X’s goods will become cheaper as its currency value drops, as goods that are exported are denominated in local currencies and prices are sticky. Conversely, the opposite happens for country X’s imports from country Y, which have now become more expensive. Consequently, if a country’s currency depreciates, its trade balance will improve as its exports increase and its imports drop. In other words, the depreciating currency economy increases its competitiveness as its firms can export more easily. Such benefits can also spread across the economy, as these export-oriented companies increase their capacity and hire more employees.
Is this true for international trade?
Gopinath et al. (2020) challenge the neo-Keynesian approach. They indicate that quantities of goods that flow from one country to another, as well as prices, are not significantly affected by bilateral currency values. This is because many internationally traded goods are priced in US dollars. Thus, it is each currency’s position versus the dollar that impacts competitiveness, rather than its relation to the currency of each respective trade partner. In their model, the authors incorporate the dollar’s central position in the global terms of trade which they describe as the ‘dominant currency paradigm’.
Figure 1: New-Keynesian models vs Dominant Currency Paradigm model
Source: Bonsai Economics, Gopinath et al. (2020)
The US dollar’s performance affects global trade
Due to the dollar’s dominance, US domestic policies that affect its value can influence international trade flows. Using a dataset of 2,500 country pairs and covering 91% of international trade, the authors highlight three main findings:
1) A 1% US dollar appreciation against all other currencies predicts a 0.6% decline in global trade within a year.
When the US dollar appreciates, demand for imports to the rest of the world decreases, since goods are more expensive in dollar terms. Moreover, the authors found that the appreciation does not lead to an equivalent increase in US imports Consequently, the dominant currency’s appreciation reduces global trade flows.
2) Country import volumes are more sensitive to the US exchange rate than to the bilateral exchange rate
Adding the US exchange rate to the effect of bilateral trade reduces the effect of the latter from 0.76 to 0.16 percentage points.
3) The higher the share of a country’s dollar-denominated goods, the more sensitive is its trade to US dollar fluctuations
US dollar dominance matters
In today’s globalized economic system, the value of the US dollar affects trade worldwide, especially in emerging economies that invoice a higher share of their goods in US dollars. The US dollar offers a stable alternative to volatile local currencies. However, it also raises the risk of weaker global trade when US monetary policy tightens to control domestic inflation, as it is currently happening. As a result, what can benefit domestic US economic stability may have a negative global economic impact.
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