Dollar invoicing, global value chains, and the business cycle dynamics of international trade

Abstract

This paper reexamines the relationship between monetary policy, exchange rates and international trade in a world characterized by the dominant currency paradigm and global value chains. Using a three-country dynamic stochastic general equilibrium (DSGE) model, it documents key differences between the response of gross and value added trade flows to interest rate shocks, and offers a framework to test them in the data. The exercise uncovers a new margin of adjustment where value added trade flows react significantly to shocks, even as gross trade flows that are typically measured in the data remain relatively flat. This provides a reconciliation between the output effects of textbook models that assume producer currency pricing and no value chains, and the low aggregate exchange rate passthrough and muted adjustment of gross trade flows that has been documented in the data.