Benoît Coeuré: The euro's global role in a changing world - a
monetary policy perspective
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, at
the Council on Foreign Relations, New York City, 15 February 2019.
* * *
Speech including graphs can be found at the ECB's website.
This year marks the 20th anniversary of the euro's creation, an event which has triggered much
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reflection on the single currency's successes and challenges.
I would like to thank J. Gräb, A. Mehl and J. Yiangou for their contributions to this speech. I remain
solely responsible for all opinions contained herein.
Most of this commentary has, rightly, focused on the economic track record of the euro area.
The main aim of monetary union was, after all, to maximise the benefits of the EU's internal
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market and thereby shift Europe onto a higher growth trajectory.
See, for example, Draghi, M. (2018), "Europe and the euro 20 years on", speech at Laurea
Honoris Causa in Economics by University of Sant'Anna, Pisa, 15 December.
I will not discuss these benefits today. Instead I will merely say that, since day one, many
commenters, including here in the United States, have predicted the imminent demise of the
euro. However, the truth is that, today, three out of four people in the euro area support the euro -
[3]
the broadest support since its creation.
See European Commission (2018), "Eurobarometer: Support for the euro steady at all-time high
levels", 20 November.
One should never underestimate the resilience and strength of Europe's monetary union project.
Today I would like to focus on a different aspect, however: the external dimension of the euro -
that is, its international role. For some Europeans, external factors have always formed part of
the case for the single currency. A currency with a global standing would not just be a symbol of
European unity on the world stage, it would also be a tool to project global influence.
Following this line of thought, it is no coincidence that the final push towards monetary union took
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place against the backdrop of the confrontational foreign economic policies of the 1980s.
See Henning, R. (1998), "Systemic Conflict and Regional Monetary Integration: The Case of
Europe", International Organization, Vol. 52, No 3, pp. 537-573.
Yet by the time the euro was launched in 1999, this protective aspect of the single currency had
rather disappeared from view. The turn of the century was the age of "the end of history", when
conflicts between great powers were seen as a relic of the past, replaced by a widespread liberal
order. The notion that countries should view their currencies as tools of foreign economic policy
became unfashionable.
As a result, few politicians in Europe took note that, after quickly establishing itself as a global
currency, the euro gradually lost international standing from the mid-2000s onwards. You can
see this on my first slide, which shows a composite index measuring the euro's international
role. Today, it stands at an historic low.
The euro's international role has declined since the mid-2000s
Index of the euro's international role
(percentages; four-quarter moving averages)
Sources: BIS, IMF, CLS, Ilzetzki, Reinhart and Rogoff (2017) and ECB calculations.
Notes: Arithmetic average of the shares of the euro at constant exchange rates in stocks of
international bonds, cross-border loans, cross-border deposits, foreign exchange settlements,
global foreign exchange reserves and exchange rate regimes. Data on the share of the euro in
global trade invoicing were not available; those on foreign exchange settlements are at market
exchange rates. The latest data are for the fourth quarter of 2017.
While the euro is the second most used currency by most measures, it often lags behind the
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dollar by a wide margin.
In 2008, some economists expected the euro to overtake the US dollar as an international
reserve currency by around 2020. See, for example, Chinn, M. and Frenkel, J. (2008), "Why the
euro will rival the dollar", International Finance, Vol. 11(1), pp. 49-73.
You can see this on Slide 2, which shows the shares of major currencies in selected measures
of international currency use.
The euro is the world's second global currency
Snapshot of the international monetary system
(percentages)
Sources: BIS, IMF, SWIFT, Gopinath (2016) and ECB calculations.
Note: Data as at the fourth quarter of 2017 or latest available.
European policymakers have woken up to these developments. There have been a series of
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calls in recent months for the euro to assume a stronger international role.
See Juncker, J.C. (2018), "The Hour of European Sovereignty", State of the Union Address 2018;
European Commission (2018), "Towards a stronger international role of the euro", European
Commission contribution to the European Council and the Euro Summit, 5 December; and
European Council (2018), "Statement of the Euro Summit", 14 December.
The main reason that I see for these calls relates to the growing perception of a shift in global
governance, from leadership built on trust and common identities - what the ancient Greeks
called hegemonia - to leadership based on arkhe, hard power where policies and doctrines are
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imposed on others.
See Coeuré, B. (2018), "Asserting Europe's leadership", panel remarks at Les rencontres
économiques d'Aix-en-Provence, 8 July.
In such an environment, being the issuer of a global reserve currency confers international
monetary power, in particular the capacity to "weaponise" access to the financial and payments
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systems.
See, for example, Tooze, A. and Odendahl, C. (2018), "Can the euro rival the dollar?", CER
Insight, Centre for European Reform, 4 December.
As has been clear on a number of recent occasions, the prospect of being shut out of major
financial systems makes fines or economic sanctions markedly more threatening.
used against it.
See, for example, European Commission (2018), ibid.
These risks are not new, of course. As Tommaso Padoa-Schioppa once noted, the demise of
the gold standard shifted monetary management away from international constraints and
towards domestic priorities. In Padoa-Schioppa's words, this is when "monetary nationalism took
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over".
"In the last century [the] history [of monetary orders] was marked by a fundamental shift in
relations between money and the two entities to which it had been anchored from time
immemorial: a commodity (mainly gold) and the 'sovereign' or, to put it another way, intrinsic
value and political power. Over the decades, the commodity anchor was relaxed while the
political anchor was correspondingly strengthened." See Padoa-Schioppa, T. (2010), "The Ghost
of Bancor: The Economic Crisis and the Global Monetary Disorder", Triffin Lecture,
Louvain-laNeuve, 25 February.
The novelty of our situation today is that these concerns extend well beyond advanced
economies. Other nations are now seeking to raise the international profile of their currencies.
The renminbi, for example, was included in 2016 in the International Monetary Fund's special
drawing rights (SDR) basket alongside the US dollar, euro, yen and pound sterling. China
recently also launched its first oil futures contract denominated in renminbi - the so-called
petroyuan - in an apparent bid to strengthen the hold of the renminbi in global energy markets.
There are certainly high barriers to other currencies displacing the dollar in the international
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financial and commodity system.
Increasing returns and network effects are important determinants of international currency
status and support the continued use of incumbent currencies. Small initial differences
accumulate over time, resulting in the disproportionate and persistent use of one currency. Early
discussions of these effects include: Krugman, P. (1984), "The International Role of the Dollar:
Theory and Prospect," in Bilson, J. and Marston, R. (eds.), Exchange Rate Theory and Practice,
Chicago: University of Chicago Press, pp. 261-278; and Rey, H. (2001), "International Trade and
Currency Exchange," The Review of Economic Studies, Vol. 68, No 2, pp. 443-464. In line with
this, it is conventionally believed that it took between 30 and 70 years for the US dollar to
dethrone the pound sterling as the leading international currency once the United States
surpassed the United Kingdom as the leading global economic powerhouse and trading nation
(see Triffin, R. (1960), Gold and the Dollar Crisis: The Future of Convertibility, New Haven: Yale
University Press). But more recent scholarly work suggests that this change occurred faster
than conventionally assumed because the increasing returns of networks may not be as strong
as commonly posited (see, for example, Chiţu, L., Eichengreen, B. and Mehl, A. (2014), "When
did the dollar overtake sterling as the leading international currency? Evidence from the bond
markets," Journal of Development Economics, Vol. 111, pp. 225-245).
Yet multi-polar currency systems existed in the not-so-distant past. Before World War One, the
pound sterling, the Deutsche Mark and the French franc all vied for global supremacy as reserve
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currencies.
See Eichengreen, B., Mehl, A. and Chiţu, L. (2017), How Global Currencies Work: Past, Present
and Future, Princeton University Press.
And the interwar period was characterised by a sterling-dollar duopoly. So, if history is any guide,
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a multi-polar system could well become a reality once again.
On the prospects for a multi-polar monetary system, see also Bénassy-Quéré, A. and Coeuré, B.
(2010), "Le rôle international de l'euro : chronique d'une décennie", Revue d'économie politique,
Vol. 120, pp. 355-377.
In fact - and you can see this on Slide 3 - some shifts are already taking place. Both the euro
and the dollar have lost similar ground as international reserve currencies since the global
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financial crisis.
Official reserve managers, including the ECB, have diversified a small part of their portfolios
towards non-traditional currencies, with the shares of the Chinese renminbi, Australian dollar,
Canadian dollar and other non-traditional units trebling to about 7% of global foreign exchange
reserves.
It remains to be seen whether this is a short-lived development or the beginning of a larger trend.
The euro and the US dollar have lost ground as international reserve currencies
Share of the euro and the US dollar in global foreign exchange reserves
(percentages)
Sources: IMF and ECB calculations.
Notes: Data adjusted for exchange rate valuation effects. The latest observations are for the
fourth quarter of 2017
So how are we as central bankers affected by these developments?
The ECB, of course, does not take a view on foreign policy questions. It is not for us to decide on
Europe's role in the world, or on which countries outside Europe choose to use the euro and
which do not. We continue to see the global role of the euro as being primarily a market-led
process.
That said, we are not indifferent to the current debate in Europe, for two major reasons.
First, we see an alignment between the policies that will strengthen the euro's global role and the
policies that are needed to make the euro area more robust. We support efforts to improve the
design of Economic and Monetary Union (EMU), and these efforts will also, indirectly, foster a
stronger international role for the euro.
Second, a stronger global role for the euro may have tangible consequences for the conduct of
monetary policy.
In my remarks this morning, I would like to explain these two points in more detail.
Policies supporting the euro's international role
The decline of the euro's international role is, on the face of it, puzzling. The euro area displays
two of the fundamental elements that economists deem essential in fostering a currency's
international use.
The first element is that it is the currency of a large economy that is comparable in economic
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size to that of the United States.
In purchasing power parity terms, the United States accounts for about 15% of world GDP,
compared with 11% for the euro area. Economic size is an important determinant of international
currency use in random matching models considering currency choice as a double-coincidence-
of-wants problem (see Matsuyama, K., Kiyotaki, N. and Matsui, A. (1993), "Toward a Theory of
International Currency," The Review of Economic Studies, Vol. 60, No 2, pp. 283-307).
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The second is that it is issued by the world's largest trading bloc.
The United States accounts for about 11% of global trade, compared with 14% for the euro area.
These two elements featured prominently in the discussions that took place 20 years ago as to
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whether the euro could match the international standing of the dollar.
See, for example, Bergsten, F. (1997), "The Dollar and the Euro," Foreign Affairs,Vol. 76, pp. 83-
95.
Secular factors unrelated to the euro area - such as the parallel rise of the renminbi - have
certainly played a role in stalling the euro's progress. But what is also clear is that establishing an
international currency is not just a matter of economic size.
You can see this clearly on Slide 4. The United States accounts for a much smaller share of the
global economy today than it did after World War II, and yet the US dollar is still, by far, the
leading global reserve currency, now like then.
Economic size is not the only factor determining global currency use
Importance of the US and the US dollar in the global economy
(percentages)
Sources: Maddison project, IMF WEO and Eichengreen, Mehl and Chitu (2016).
Note: Share of the US in global GDP in PPP terms. The last observation is for 2017.
This suggests that factors specific to the euro area are likely to have prevented the euro from
rising more forcefully as an international currency. I see these factors as closely related to three
broad shortcomings in the institutional design of the EU and EMU:
First - the ability to provide stability both domestically and internationally.
Second - the limited depth and liquidity of euro area financial markets.
And third - Europe not speaking with one voice on international matters, including national
security.
An international currency must be stable
Take stability first. Empirical research confirms that, next to size and openness, stability is a key
determinant of international currency use. But stability means different things to international
investors, who hold the currency as a store of value, and international borrowers, who use it as a
financing vehicle.
For borrowers, broadly speaking, stability derives primarily from central banks' monetary policy
frameworks. Research finds that the currencies that become dominant in international financing
are the ones whose central bank actively pursues an inflation stabilisation policy that protects
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borrowers' real debt burdens.
This is the essence of the international Fisher debt-deflation channel which works through the
effects of monetary policy on the exchange rate and inflation risk premia (see Eren, E. and
Malamud, S. (2018), "Dominant Currency Debt", CEPR Discussion Paper, No 13391).
the IMF s SDR basket.
"We believe that currencies of large economies heavily used in international trade and financial
transactions should become part of the SDR basket, and that to achieve this objective, the
concerned countries should have flexible exchange rate systems, independent central banks,
and permit the free movement of capital flows." See Geithner, T. (2011), Statement at the
Highlevel Seminar on the International Monetary System, Nanjing, 31 March.
For investors, stability mainly comes from a currency's ability to act as a safe haven in times of
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global financial stress.
Certain academics have created models to show that currency depreciations make holding a
unit unattractive and discourage its international use insofar as it will not be perceived as a
reliable store of value. For example, see: Devereux, M. and Shi, S. (2013), "Vehicle Currency,"
International Economic Review, Vol. 54(1), pp. 97-133.
This is what some have coined the "exorbitant duty" of international currency status, which
offsets the "exorbitant privilege" in crisis times, since it leads to negative wealth effects for the
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currency issuer.
See Gourinchas, P.-O., Govillot, N. and Rey, H. (2011), "Exorbitant Privilege and Exorbitant
Duty", Working Paper Series, University of California, Berkeley. See also Caballero, R., Farhi, E.
and Gourinchas, P.-O. (2015), "Global Imbalances and Currency Wars at the ZLB," NBER
Working Paper, No 21670.
Theoretical work suggests that investors are more likely to perceive sovereign debt as safe if the
fundamentals of the issuer are strong relative to other possible issuers, but not necessarily
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strong on an absolute basis.
See He, Z., Krishnamurthy, A. and Milbradt, K. (2019), "A Model of Safe Asset Determination,"
American Economic Review, forthcoming.
This may explain, for example, why investors did not rebalance away from US Treasuries
throughout the global financial crisis, despite the stark deterioration in the United States' fiscal
position.
For currency unions, however, absolute fundamentals arguably matter more. The reason is that,
in the absence of a common consolidated balance sheet, sovereign debt exhibits a higher
degree of credit risk than it does in economies that can pursue their own monetary policy. Public
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debt can therefore behave like private debt when risk aversion rises.
See Coeuré, B. (2016), "Sovereign debt in the euro area: too safe or too risky?", keynote address
at Harvard University's Minda de Gunzburg Center for European Studies, 3 November.
This fact was not unknown. The idea of the euro was always that a credible set of fiscal rules
would ensure that national sovereign debt would be safe. But the euro area debt crisis exposed
flaws in the design of our monetary union.
With the crisis, the number of AAA-rated euro area sovereigns fell from eight to three. Today,
AAA-rated euro area sovereign debt amounts to just 10% of GDP. In the United States it is more
than 70%. You can see this on Slide 5.
The supply of euro area safe assets has declined and is small relative to the US
Outstanding amount of AAA-rated debt securities issued by euro area central governments
(EUR billions)
Sources: OECD Government Statistics and ECB staff calculations.
Notes: Outstanding amounts at market value. The blue bars in the chart report debt securities
issued that are rated AAA/Aaa both by Standard and Poor's and Moody's (local currency
longterm debt rating). Totals for 2007 includes Austria, Finland, France, Germany, Ireland,
Luxembourg, the Netherlands and Spain. Totals for 2018 include Germany, Luxembourg and the
Netherlands.
Debt securities issued by central governments
(2018; as percent of GDP)
Sources: OECD Government Statistics, IMF WEO and ECB staff calculations.
Notes: Outstanding amounts at market value for the euro area; publicly held Treasury securities
outstanding for the US. See the preceding footnote for definitions of the rating universe.
But Europe has learnt its lesson. Considerable efforts have been made in recent years to
improve the euro area governance framework, and work is still ongoing. We now have a single
supervisor for large banks, a single framework for resolving failing institutions, a single fund to
finance those resolution activities and, soon, a single backstop for that fund.
We have also established the European Stability Mechanism, which provides a safety net for
sovereigns threatened with losing market access, provided that they implement sound economic
policies.
But for the euro to act as a true, effective hedge in times of stress, and therefore to attain and
maintain international status, we need to further strengthen the fiscal dimension of EMU.
Sound fiscal and structural policies are needed to provide international investors with what they
need most: a large and elastic supply of safe assets. The fact that the supply of
eurodenominated safe assets can shrink at precisely the time when demand for such assets is rising
has not been lost on investors. It is likely a dominant factor keeping the euro from having a
stronger international role.
We know that the journey towards a true European safe asset, one that does not vanish on rainy
days, will be long and full of perils. While progressing towards this objective, we should thus also
focus our efforts on "upgrading" the credit quality of outstanding liabilities, which can only be
achieved if governments make public debt more sustainable by committing to credible fiscal
rules.
The need for deeper and more liquid capital markets
The second, and related, shortcoming of EMU is the segmentation of its capital markets.
Deep and liquid financial markets are fundamental to a currency's ability to attain international
status. They reduce transaction costs, making the currency more attractive for international
financing and settlement, and - as more liquid markets mitigate rollover risk - they are perceived
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as safer by investors.
The dynamic interaction between debt liquidity and safety is non-trivial, however, as shown in He
et al. (2019), op. cit. If global demand for safe assets is high, large debts can enhance safety
because they offer greater liquidity and so reduce rollover risk. Conversely, if demand for safe
assets is low, large debt may increase rollover risk.
This is not just theory. Recent research shows that capital market depth was critical in helping
the US dollar to catch up with, and then overtake, the pound sterling in the first half of the last
century. Financial deepening was by far the most important contributor to the increase in the
share of dollar-denominated international bonds issued between 1918 and 1932. Its impact
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dwarfed that of economic size or credibility.
Chiţu, L., Eichengreen, B. and Mehl, A. (2014), op. cit.
European capital markets appeared to be becoming more integrated, and hence deeper, prior to
2008. But this impression was based more on price convergence than on real cross-border
integration. You can see this clearly on Slide 6, which shows composite indicators of euro area
financial integration produced by the ECB. The quantity-based indicator remains at about half of
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its pre-crisis peak, and at very low levels in absolute terms.
The price-based composite indicator is about 30% below.
Financial fragmentation has weighed on the euro's global standing
Financial integration in the euro area
(indices)
Source: ECB.
Notes: The price-based composite indicator aggregates ten indicators covering the period from
the first quarter of 1995 to the fourth quarter of 2017, while the quantity-based composite
indicator aggregates five indicators available from the first quarter of 1999 to the third quarter of
2017. The indicators are bounded between zero (full fragmentation) and one (full integration).
Increases in the indicators signal greater financial integration. For a detailed description of the
indicators and their input data, see ECB (2018), Financial integration in Europe, Frankfurt am
main. The latest data are for the third quarter of 2018.
Cyclical factors and the "doom loop" between euro area banks and sovereigns have certainly
aggravated market segmentation. But the underlying reasons for it are structural. Capital markets
in Europe are still fragmented along national lines, since various legal and institutional barriers
hinder the creation of a single pool of liquidity.
This is precisely why policymakers have now put their weight behind the capital markets union
(CMU) project. But progress remains too slow. We at the ECB see CMU as a key priority for the
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next European Commission and Parliament.
See Building a Capital Markets Union - Eurosystem contribution to the European Commission's
GreenPaper, 21 May 2015.
The ECB has been complementing these efforts by upgrading its payment system infrastructure,
which contributes to market integration and, in turn, to the depth and liquidity of euro area
securities markets. Recent initiatives include the successful launch of our securities settlement
platform TARGET2-Securities, a new platform for instant payments and the upgrade of our
largevalue transactions TARGET system. In time, these systems may offer international market
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participants easier access to our currency.
The new platform for instant payments launched by the ECB in November 2018 might offer an
alternative to credit cards for payments online. The reform of the large-value transactions
TARGET system would make it technically possible to establish direct links with comparable
systems worldwide. In turn, this would enable settlement of foreign exchange transactions and
offer an alternative to other systems.
International currencies carry a security premium
The third and final factor that is likely to have held back the international role of the euro relates to
the EU's ability to speak with one voice on international affairs.
I will venture very warily into what is certainly not central bankers' territory. But empirical evidence
supports the view that the US dollar benefits from a substantial security premium. Nations that
depend on the US security umbrella hold a disproportionate share of their foreign reserves in
dollars.
Global geopolitical outreach matters for international currency status
Predicted share of the US dollar in the foreign exchange reserves of selected countries
(percentages)
Source: Eichengreen, B., A. Mehl and L. Chiţu (2019).
Note: The figures show the predicted shares of the US dollar in the foreign reserve holdings of
five countries which depend on the US security umbrella. Predicted shares are computed under
two scenarios: (i) using estimates from a model restricted to standard economic determinants of
international currency choice (shown as yellow bars); and (ii) using estimates from a model
expanded to include the effect on international currency choice of the countries' NATO
membership (shown as red bars). Actual US dollar shares are shown as blue bars. The actual
dollar shares are based on publicly available estimates for the year 1987 (Korea), 2004
(Germany), 2006 (Japan), 2007 (Saudi Arabia) and 2016 (Taiwan); see Eichengreen et al. (2019)
for further details on the sources for the data.
You can see this on Slide 7: a model restricted to economic factors - the yellow bars -
underpredicts, by a wide margin, the dollar reserves of countries dependent on the United States for
their security. A model including their NATO membership - the red bars - comes much closer to
the actual shares. By one estimate, military alliances boost the share of a currency in the partner
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country's foreign reserve holdings by about 30 percentage points.
See Eichengreen, B., Mehl, A. and Chiţu, L., "Mars or Mercury? The Geopolitics of International
Currency Choice", Economic Policy, forthcoming.
This is not a new phenomenon. During the late 19th century, a growing share of Deutsche Marks
in Austria-Hungary's reserves went hand in hand with the Triple Alliance, i.e. the secret
agreement between Germany, Austria-Hungary and Italy signed in 1882 and renewed periodically
until World War I. The increasing importance of French francs in Russia's reserves in the years
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after the Franco-Russian alliance of 1894 reflected similar security patterns.
Ibid.
Of course, this aspect of a currency's international status extends beyond EMU. But it has a
clear implication for policymakers. Europe already exerts global leadership in regulatory,
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competition and trade domains.
Europe already exerts global leadership in the regulatory domain. The obligation for companies to
respect EU standards when exporting products to the Single Market, combined with the size of
this market, means that the EU tends to influence standards elsewhere - the so-called Brussels
effect. The EU is the top trading partner for no fewer than 80 countries.
European initiatives to foster cooperation on security and defence, to speak with one voice on
international affairs, and, in short, to further assert global leadership, might also help promote the
euro's global outreach.
The monetary policy consequences of a greater international role for the euro
Now, one important aspect that is often overlooked in the debate about strengthening the
international role of the euro is what it would mean for the ECB's monetary policy. This is what I
would now like to discuss.
As I see it, the monetary policy relevance of an international currency has probably increased
over time, on account of both the evolution of the international monetary system itself and the
way central banks implement monetary policy today, in particular at the zero-lower bound.
More specifically, I see three broad implications for the conduct and transmission of our
monetary policy, all of which we would need to understand and take into account when defining
the appropriate stance for the euro area.
First is the effect on exchange rate pass-through.
This is in part mechanical: the more the domestic currency is used for trade invoicing, the less
the pass-through to import prices in the face of fluctuations in the exchange rate. This holds not
only over the short run, when prices are sticky, but also over the long run when they are adjusted
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by producers.
See Gopinath, G., Itskhoki, O. and Rigobon, R. (2010), "Currency Choice and Exchange Rate
Pass-Through", American Economic Review, Vol. 100, No 1, pp. 304-336.
The tight correlation between domestic currency invoicing and exchange rate pass-through is
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evident in the euro area.
For further details, see ECB (2015), "The international role of the euro", Frankfurt am Main, July.
As you can see on the left-hand chart of Slide 8, euro area countries with a greater share of
imports invoiced in euro - those on the south-east corner of the chart - are more insulated from
fluctuations in the euro exchange rate and have lower pass-through to import prices.
International currency status lowers exchange rate pass-through
Exchange rate pass-through to import prices vs. euro invoicing across euro area countries
Source: The international role of the euro, ECB, July 2015.
Notes: Long-run exchange rate pass-through is estimated using a standard log-linear regression
model of the quarterly log change in import price unit values on the quarterly changes of the
standard broad measure of the NEER-38 of the euro, a quarterly effective measure of inflation in
production costs of the euro area's major trading partners and the quarterly log change in
industrial production (excluding construction). The estimation sample spans the time period from
the first quarter of 2000 to the last quarter of 2014. The share of euro invoicing reported on the
xaxis is the average over the sample period. The black line is a fitted regression line.
Exchange rate pass-through to euro area import prices in response to a monetary policy shock
(percent)
Source: ECB calculations based on Casas et al. (2017).
Note: The figure plots the impulse response of import prices to a negative 25 basis point cut in
the short-term interest rate leading to 1% depreciation in the exchange rate under local currency
(euro) pricing and dominant currency (dollar) pricing obtained in a calibrated small
openeconomy model.
The degree of pass-through, in turn, has a strong influence on the transmission of shocks, which
has differing implications for monetary policy.
On the one hand, lower pass-through means that import prices are better shielded from
exogenous exchange rate shocks, and monetary policy can focus more on domestic sources of
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inflationary pressures.
Price increases in local currency by exporters will, of course, still be transmitted to domestic
consumer prices.
As of today, more than 90% of US imports are invoiced in US dollars. By comparison, less than
50% of extra-euro area imports are invoiced in euro. If this share were to increase to, say, 70%,
the sensitivity of import prices to exchange rate movements would decline by around one-third.
On the other hand, the effect of domestic monetary policy on import prices is more limited when
pass-through is low. You can see this on the right-hand chart, which plots simulations from a
calibrated model of the exchange rate pass-through. Clearly, increased local currency pricing
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would, in principle, attenuate an important lever of monetary policy.
The estimates are taken from Casas, C., Diez, F., Gopinath, G. and Gourinchas, P.-O. (2017),
"Dominant Currency Paradigm: A New Model for Small Open Economies", IMF Working Papers,
No 17/264.
But it is also true that, in