The classical argument in favour of free-floating exchange rates is that they allow monetary policy to circumvent price stickiness – a depreciation of the nominal exchange rate generates expenditure switching towards exported goods in foreign markets and stimulates a country's output (Friedman 1953). This mechanism is the cornerstone of the canonical Mundell-Fleming paradigm, as well as the workhorse models of an open economy (Gali and Monacelli 2005). However, the effectiveness of the expenditure-switching channel relies heavily on the assumption that export prices are set in the producer's currency (Devereux and Engel 2003). Recent evidence shows that this assumption provides a poor approximation to the real world as most international prices are set in one dominant currency – the US dollar (Goldberg and Tille 2008, Boz et al. 2020). As a result, international trade flows depend mostly on the US exchange rate diminishing the potency of an exporter's monetary policy (Gopinath 2016, Boz et al. 2018, Amiti et al. 2020).
This naturally raises the question of whether the conventional policy prescriptions survive under dollar currency pricing (DCP). In particular, is the floating exchange rate still optimal or can a peg be preferred? Should the monetary policy be complemented with additional tools such as capital controls and FX interventions? Are there gains from international cooperation? Should the Federal Reserve be concerned about global spillovers of its policy? Does the US benefit from the dominant status of its currency? Studying these questions in a context of a standard open economy augmented with dollar pricing (Egorov and Mukhin 2021), we establish the following results on the optimal policy:
Implication 1: The optimal non-US monetary policy stabilises domestic inflation rather than the exchange rate, even though the resulting allocation is not fully efficient.
Despite the weaker expenditure-switching effects, we find that inflation targeting is robustly optimal under DCP and there is no reason to peg exchange rates. Remarkably, the optimal target is exactly the same as in a closed economy or in an open economy with producer currency invoicing. In contrast to these two cases, however, the divine coincidence does not hold under dollar pricing and stabilising inflation is not sufficient to close the output gap. Intuitively, without expenditure-switching channel, monetary policy cannot directly stimulate a country's exports. The best thing the central bank can do in this case is to ensure that local demand for domestically produced goods is at the optimal level, which corresponds to stabilising domestic prices. Overstimulating the domestic sector does not help with a country's exports, and imports and can only lower the welfare. Thus, in a similar way to the results of the complementary ‘global financial cycle’ literature (Rey 2015), the trade-off facing the policymakers in non-US economies is worsened by DCP, transforming the trilemma into a dilemma. At the same time, this does not mean that the monetary authorities should peg the exchange rate, as that would not allow them to stabilise the domestic sector. Of course, in practice, there might be several reasons to peg the exchange rate, but our analysis shows that DCP is not one of them.
Implication 2: The policy-relevant price index is based on prices of goods invoiced in local currency.
What measure of inflation should a central bank use? Interestingly, we show that the composition of the price index targeted by the optimal policy is based on the currency of invoicing rather than the country of origin. On the one hand, the index does not include the prices of exported goods, which are produced locally but are denominated in dollars. On the other hand, it does include the retail prices of imported goods that are usually set in domestic currency, even if their border prices are in dollars. As a result, the optimal target might be closer to the core CPI rather than to the PPI.
Implication 3: DCP leads to a global monetary cycle where other countries import the monetary stance of the US.
The fact that monetary policy targets domestic inflation does not mean that it is inward-looking and insulated from foreign shocks. On the contrary, DCP makes foreign economies highly sensitive to US shocks and leads to the global monetary cycle – a co-movement of interest rates across economies, even when fundamental shocks are not correlated between countries. A tightening of US policy leads to the appreciation of the dollar and increases international prices in the currency of destination. On the one hand, this raises import prices and puts inflationary pressure on monetary authorities. On the other hand, it also lowers demand for exported goods and requires expansionary monetary policy to stabilise falling wages. The net effect is ambiguous and depends on the relative strength of the two channels. In particular, emerging economies (e.g. Russia) that export flexible-price commodities and import sticky-price manufacturing goods are expected to have a stronger import channel and to increase their interest rates when the dollar appreciates. The opposite is true for developed economies (e.g. Japan), which import commodities and exhibit a stronger export channel. The monetary response is weaker for economies that are more closed and rely less on dollar pricing (e.g. the euro area).
Implication 4: Unilateral capital controls and FX interventions are redundant and should not be used.
Given that the optimal monetary policy does not fully close the output gap, the government might be keen to supplement conventional interest rate policy with macroprudential tools such as capital controls and FX interventions (Blanchard 2017). However, we find that these instruments are highly inefficient and should not be used against the DCP spillovers. Intuitively, macroprudential policy can change domestic demand, but has only trivial effects on global demand. Given that it is foreign demand for exported goods that is the key source of distortions under DCP, such policies can do little to help the economy. To be clear, our result should not be interpreted as an argument against the macroprudential policy, which might be important to offset financial spillovers (Bianchi 2011) or the aggregate demand externality (Schmitt-Grohe and Uribe 2016). Instead, it shows that unilateral capital controls are not a panacea and cannot insulate a country from spillovers arising from DCP.
Implication 5: The depreciation of the dollar stimulates foreign output and is unlikely to cause a currency war.
Many policy debates have been focused recently on whether the depreciation of the dollar leads to a zero-sum game of currency wars (Bernanke 2017). It has been argued in particular that the negative spillovers of US policy on foreign output are especially strong when the global economy is in a liquidity trap (Caballero et al. 2016). Once again, dollar invoicing changes the perspective: in contrast to the case of producer currency pricing, a depreciation of the US dollar decreases the prices of all internationally traded goods, not only of goods exported from the US. This lowers import prices and consumer prices at the global level. With the aggregate nominal demand unchanged, a fall in prices increases real demand, stimulating production in the global economy. This channel has an unambiguously positive effect on foreign output and outweighs the standard expenditure switching towards US goods (Mukhin 2018).
Implication 6: The optimal cooperative policy prescribes that the US stabilises the international price index, while other countries redistribute demand towards countries importing depressed goods.
There are two sources of gains from international cooperation under DCP. First, US monetary policy should internalise its spillovers on international trade and stabilise global demand for dollar-invoiced goods. This improves exports of other economies and increases their welfare. To do this, however, the US would sacrifice its domestic objectives without getting much in return, making international cooperation hard to sustain. The conflict of interest is especially pronounced when countries are in different phases of the business cycle. Second, while unilateral capital controls are inefficient, the coordinated use of macroprudential tools and/or ex-post transfers between countries can reduce the world output gap. The important practical recommendation here is that policy should target the importers of depressed goods rather than the exporters: local demand is optimal thanks to the monetary policy and the transfers aim to stimulate demand for foreign goods.
Implication 7: The issuer of the dominant currency benefits from the global status of its currency.
While the welfare implications of DCP are ambiguous in the general case, we find that the US is likely to gain from the dominant status of the dollar. Not only is the issuer of the dominant currency more insulated from foreign spillovers, but it can also extract rents in international goods and asset markets. It follows that there are incentives for other economies, including the euro area and China, to promote their currencies on the global stage.
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