The dollar and the "dominant currency paradigm" - There is good news from a dollar decline

When thinking about the dollar investors should understand current thinking about currency economics. There is a new view that has emerged that should drive thinking about global growth and trade, the Dominant Currency Paradigm (DCP). 

Most who have been taught any international trade and finance are familiar with stories of concerning the law of one price, or some version of stick prices which will impact terms of trade and competitiveness. The law of one price means that a depreciation will raise the price of imports relative to exports (terms of trade) and thus increase competitiveness. This has been referred to as the PCP or producer currency pricing paradigm. The alternative or local currency pricing (LCP) paradigm says that sticky prices in the currency of the destination markets leads to lower price of imports relative to exports and reduces competition. The problem is that research on invoice pricing shows neither economic story represents reality.  

Reality can be explained by the DCP, whereby exports are priced with a few dominant currencies and change prices infrequently. In a more complex world of trade with intermediary production, global commodities, and financing in dollars, the DCP can explain the current trade environment and show how the dollar moves can spillover to trade around the world. In a dollar DCP, the Fed is not the central banker for the US, not the financier of the globe,  but the arbiter of profits and trade flow across the world. 

The DCP paradigm can be described through the following stylized facts that have strong empirical support, (See "Dominant Currency Paradigm" American Economic Review March 2020):

• Firms set exports in a dominant currency and change currencies infrequently. Invoicing in the dominant currency will affect terms of trade and the quantity traded in a manner not expected in traditional models.
• In the short and medium term, the terms of trade are insensitive to exchange rate changes. It is hard to change the terms of trade when a large proportion of traded goods are priced in the dominant currency.
• For non-US countries, the exchange rate pass-through into import prices should be high and driven by the dollar fluctuations and not bilateral exchange rates. For the US, the dominant currency, pass-through into import prices will be low. 
• For non-US countries, import quantities will be driven by dollar fluctuations and not bilateral exchange rates. US imports will be less sensitive to dollar exchange rate changes. 
• When the dollar appreciates (depreciates), there should be a decline (increase) between countries in the rest of the world. 

Large changes in the value of the dollar will have a major effect of global trade and growth and its move extends beyond US interests; nonetheless, a dollar decline may have positive spill-over effects. A dollar decline will be good for trade across other countries and may be a good signal for increasing non-US equity exposure.