Federal Reserve Bank of New York Staff Reports

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1 Fral Rr Ban o Nw Yor Sta Rport Vhicl Currncy U in Intrnational Tra Lina S. Golbrg Céric Till Sta Rport no. 00 January 005 Thi papr prnt prliminary ining an i bing itribut to conomit an othr intrt rar olly to timulat icuion an licit commnt. Th iw xpr in th papr ar tho o th author an ar not ncarily rlcti o iw at th Fral Rr Ban o Nw Yor or th Fral Rr Sytm. Any rror or omiion ar th rponibility o th author.

2 Vhicl Currncy U in Intrnational Tra Lina S. Golbrg an Céric Till Fral Rr Ban o Nw Yor Sta Rport, no. 00 January 005 JEL claiication: F3, F4 Abtract Although currncy inoicing in intrnational tra tranaction i cntral to th tranmiion o montary policy, th orc motiating th choic o currncy ha long bn bat. W introuc a mol whrin agnt inol in intrnational tra can inoic in th xportr currncy, th importr currncy, or a thir-country hicl currncy. Th mol i ign to contrat th contribution o macroconomic ariability with that o inutrypciic atur in th lction o an inoic currncy. W how that proucr in inutri with high man laticiti ar mor lily than proucr in othr inutri to iplay hring in thir choic o currncy. Thi inutry-rlat orc i mor inluntial than local macroconomic prormanc in trmining proucr choic. Drawing on ata on inoic currncy u in xport an import or twnty-our countri, w ocumnt that th ollar i th currncy o choic or mot tranaction inoling th Unit Stat. Th ollar i alo xtnily u a a hicl currncy in intrnational tra low that o not irctly inol th Unit Stat. Conitnt with th rult o our mol, thi lat ining i largly attributabl to intrnational tra in rrnc-pric goo an goo tra on organiz xchang. Although th magnitu o buin cycl olatility mattr or inoicing o mor irntiat prouct, it i l cntral or inoicing nonirntiat goo. Ky wor: currncy, inoicing, hicl currncy, pa-through, xchang rat, proucr currncy pricing, local currncy pricing Golbrg: Rarch an Statitic Group, Fral Rr Ban o Nw Yor (-mail: [email protected]), an NBER. Till: Rarch an Statitic Group, Fral Rr Ban o Nw Yor (-mail: [email protected]). Th author than Lar Snnon, Hln Ry, Dai Wintin, an minar auinc at Columbia Unirity an Princton Unirity or aluabl commnt. Gory Barrow, Elanor Dillon, Lui Gonzalz, an Matthw Konratowicz proi carul an ilignt rarch upport. Th iw xpr in th papr ar tho o th author an o not ncarily rlct th poition o th Fral Rr Ban o Nw Yor or th Fral Rr Sytm.

3 I. Introuction In which currncy houl xportr t th pric o thir goo? Whn lling to a orign mart, an xporting irm ha thr option. It can inoic th tranaction in it own currncy (proucr currncy pricing, PCP), in th currncy o th tination country (local currncy pricing, LCP), in a thir currncy (hicl currncy pricing, VCP), or in a combination o th. Which o th thr option i bt or th irm i not traightorwar rom a thortical prpcti. In thi papr, w contribut to thi iu both thortically an mpirically. W how th intraction btwn macroconomic ariability an inutry atur in inluncing inoic currncy lction. W argu that th prr o Walraian typ goo, charactriz by a high pric laticity o man, promot hring in a ingl currncy. In an inutry whr goo ar clo ubtitut, a irm ha an incnti to limit th momnt o it pric rlati to that o it comptitor, laing it to inoic in th am currncy a thy o. Thi atur la to a currncy bcoming th ominant mium o inoicing in th mart. Macroconomic ariability play mor o a rol or irntiat prouct. W montrat th point mpirically, atr prnting an analyzing rich nw ata on th actual inoic currncy choic on th xport an import o twnty-our countri. Our analyi buil on a rich hitory o thought on hicl currncy lction. Swoboa (968, 969) tr th rol o tranaction cot in traing irnt currnci, an proi arly argumnt that currnci u a mium o xchang woul b tho aociat with low tranaction cot. Such low cot coul or intanc rlct a high gr o liquiity in th orign xchang mart or th currnci in qution. Mor rcntly, Ry (00) lgantly xpoit thi thm in a thr-country gnral quilibrium mol, conirming th importanc o a currncy thic mart xtrnaliti ariing rom a larg prnc in global intrnational tra an low tranaction cot o xchang. McKinnon (979) mphaiz th rol o inutry charactritic. H argu that inutri whr goo ar homognou an tra in pcializ mart lily to b inoic in a ingl low tranaction cot currncy. Krugman (980) point to th prnc o inrtia in hicl currncy lction. Whn a currncy i tablih a th ominant on in a mart, a particular irm ha no incnti to inoic in an altrnati currncy a thi woul la to highr tranaction cot an

4 mor olatil al bcau o momnt in it pric rlati to it comptitor. Onc a currncy ha acquir a prominnt rol, bcau o low tranaction cot or intanc, it may p thi rol n i anothr currncy with imilarly low cot mrg. Macroconomic ariability ha liwi bn or a a rir o hicl currncy choic. Gioannini (988) wa prhap th irt rarchr to ormaliz th rol uch ariability on both proucr proit maximization an th lction o hicl currnci. Drux, Engl an Storgaar (004) ha a imilar mphai, but inta u a gnral quilibrium tup to introuc a rol or montary luctuation in th inoicing ciion. Th lgantly how that in a two country worl, a high olatility o montary tanc in ithr country la to a high olatility o th xchang rat, laing proucr to t thir pric in th currncy o th low olatility country. Engl (003) xtnt u a imilar tup to highlight th paralll btwn th choic o inoicing whn pric ar ticy an th optimal gr o xchang rat pa-through whn pric ar ully lxibl. W prnt a thortical mol intn to nt om o th thm. Although our analyi i partial quilibrium, w xtn Drux, Engl an Storgaar (004) in two y imnion. Firt, w conir a mol with thr countri in orr to tablih conition or lction o non-countrparty hicl currnci. Scon, w proi an xplicit rol or inutry-pciic charactritic in inluncing th inoic currncy choic. Thi xtnion i ntial or capturing om o th McKinnon-Krugman-Ry inight. W how that, in any country, proucr with iring gr o prouct homognity can ma irnt inoicing choic or thir intrnational tra tranaction. Proucr in a inutry with homognou goo aim at ping thir pric in lin with thir comptitor, laing thm to inoic in th currncy that ha a ominant rol or th inutry. By contrat, proucr tranacting in irntiat goo S alo Bacchtta an an Wincoop (00) an Drux an Engl (00). Donnnl an Haug (00, 000) loo at th rol o xchang rat olatility in riing th inoicing ciion or Canaian tra tranaction. Thy conclu that a highr olatility ma LCP mor attracti, or VCP proi that goo ar not too ubtitutabl. Th concluion ar in contrat to th on icu abo, an may b rin by th particular natur o th (nontanar) mol u. In thir mol output i prt irt, t pric ar t, an thn al ta plac. Th mor tanar mol ha pric t irt an thn output man trmin. S alo Oi, Otani, an Shirota (004) in which a gnral quilibrium mol o inoic currncy choic i prnt an appli to Japan ata. Hartmann (998) rcntly xplor hicl currncy choic rom a mart microtructur prpcti.

5 car l about limiting th momnt o thir pric rlati to thir comptitor, an ocu mor on macroconomic olatility. Thi thory proi a nic bacgroun or our nol an xtni mpirical inc on th currncy inoicing o intrnational tra or 4 countri. A broa charactrization, w conirm that th U.S. ollar i th primary, but not uniqu, inoic currncy choic in tranaction inoling th Unit Stat a a countrparty. Th uro ha rplac th lgacy currnci in uro-ara tranaction an ha iplac th ollar mainly in om tranaction o Europan Union accion countri (ECB 003). Th ollar rmain an important inoicing currncy in tranaction inoling Aian countri, Autralia, an th Unit Kingom, among othr. Our analyi o thi ata ral othr mor nuanc pattrn in th u o th ollar a a hicl currncy in intrnational tranaction. Within th w countri or which inutry tail on inoicing ar aailabl, w obr ubtantial cro-inutry ariation in th xtnt to which th ollar i a hicl currncy on tra. For th largr group o 4 countri, w xplor whthr a lination o typ o goo tra by gr o prouct ubtitutability xplain aggrgat inoicing currncy choic on xport an import. Spciically, w tablih thi htrognity atr applying th Rauch (999) ntwor inic to th tra compoition o ach o th countri. Th inic nabl u to trmin th har o a country xport an import in homognou / high laticity o ubtitution goo (i.. rrnc-pric goo, goo tra on organiz xchang) ru in irntiat prouct. Whil out thory argu or th poibility o hring in any currncy, th ata how th ollar u a a hicl currncy in country tra with non-u.s. countrparti i tightly corrlat with th pralnc in a country xport or import o tranaction in th (Walraian) organiz xchang-tra an rrnc pric goo. 3 Th obration o not prclu a rol or macroconomic ariation in inoic currncy lction. Howr, our conomtric analyi how that th inutry compoition o a country xport i much mor important or inoicing than th 3 A tail in Rauch (999), Organiz Exchang tra goo cor prouct that ha an ort mart (i.. prciou mtal). Rrnc Pric goo ar homognou goo that nonthl o not ha a ubtantial nough olum to ha an "oicial" mart (.g. obcur chmical prouct), but ar homognou nough to ha "rrnc" pric that ar publih in tra magazin. 3

6 countri participating in th tra tranaction. Our rult o not upport a trong rol or tanar buin-cycl magnitu ariation in hicl currncy lction. Th inutry ct ar mot pronounc in tra in mor homognou prouct. Small gr o macroconomic olatility ar not lily to iturb currncy inoicing quilibria or th trong rol o th ollar in th xport an import tranaction inoling mor homognou goo. Orall, w how thortically an mpirically th hring in inoic currncy choic or Walraian goo. An implication i that, abnt larg macroconomic hoc that coul potntially iturb thi tablih hicl currncy quilibrium, th pralnc o th ollar a a worlwi hicl currncy may b ti to th har o homognou goo in worl tra an to th har o th U.S. a a irct countrparty in intrnational tra tranaction. Whil Rauch (999) ha argu that tra barrir play itinct rol in th contxt o irntiat prouct ru homognou prouct, w liwi in that macroconomic ariabl ha itinct rol in th trmination o currncy inoicing choic acro th typ o goo. II. A Thr-Country / Thr Currncy Mol o Inoic Currnci Sral rcnt tui xplor conition unr which a irm will t it xport pric in it own country currncy, in which ca th pric pai by orign conumr mo with th xchang rat, or in th currncy o it cutomr abroa, in which ca th irm bar th xchang rat ri. 4 Th xiting thortical wor limit an xportr to two currnci in hr ciion, inoicing ithr in hr own currncy (PCP) or th currncy o hr cutomr (LCP). Whil th mol ar concptually rich, thy ignor th poibility that th xportr coul choo to inoic in a thir hicl currncy (VCP), that i nithr hr currncy nor that o hr cutomr. W broan th thortical moling o currncy choic or tra inoicing, loping th intraction btwn inutry atur an macroconomic ariability in a nw opn-conomy macro mol with pric rigiiti that buil on Drux, Engl an Storgaar (004). Although w o not ri a ull-blown gnral quilibrium rion 4

7 o our mol, w nonthl xtn th xiting thory in ral y imnion. Firt, w mo rom a two-country / two-currncy worl to a worl coniting o thr countri an thr currnci, thrby allowing or inoicing in a hicl currncy that blong nithr to th xportr or importr hom mart. Th u o a pciic currncy in inoicing intrnational tra tranaction can now b broar than th importanc o that currncy hom country a a irct countrparty in intrnational tra tranaction. Scon, w contrat th rol o inutry charactritic, uch a th ubtitutability btwn comptitor' goo, with macro-conomic actor, uch a buin cycl an xchang rat olatility. W how that inutry charactritic ar mor rlant or inutri whr goo ar clor ubtitut. Conir th ituation o a irm lling to a orign mart. With pric in th mart t in irnt currnci, xchang rat luctuation will act th pric o th irm goo rlati to that o it comptitor, laing to luctuation in th quantiti ol. I thr i littl irntiation btwn th goo prouc by irnt irm, n mall momnt in rlati pric gnrat larg momnt in ach irm quantity ol. Th irm thn ha an incnti to limit th luctuation o it rlati pric by chooing a tra inoicing tratgy clo to that o it comptitor. Thi la to a typ o hring bhaior in inoic currncy choic a th xportr o a rlatily homognou prouct choo to inoic in th currncy that i u by th majority o othr llr. Thir, w introuc craing rturn to cal in prouction. A pciication with contant rturn to cal limit th rult o th mol, a point rcogniz by Drux, Engl an Storgaar (004), inc a irm marginal cot i not act by luctuation in it output. Output olatility, tmming rom olatil pric rlati to th irm comptitor or intanc, thn ha no irct cot implication. Drux, Engl an Storgaar (004) maintain th aumption o a contant rturn to cal tchnology, but ar thi limitation by introucing a lin through which output olatility la to olatility in wag. Whil gnrating a channl through which output olatility act marginal cot, thir apparatu rquir wag to rpon to hort run momnt in man, a atur that i iputabl. W choo inta to mol a tchnology with 4 A non-xhauti lit inclu Bacchtta an an Wincoop (00), Cortti an Pnti (00), Drux, Engl an Storgaar (004). 5

8 craing rturn to cal, o that an incra in output la to an incra in th marginal cot n whn wag ar not rponi. Orall, th thory proi blow mphaiz th rol o prouct ubtitutability an macroconomic ariability in a ingl thortical ramwor. Although w limit ourl to a partial quilibrium mol, thi proi u with mor lxibility whn w turn to th mpirical ction. 5 Whil w can gt macroconomic ariability to play th typ o rol lai out in rcnt thortical tui, our xtnion imply that macroconomic ariability i an important coniration only whn th tra tranaction ar in irntiat prouct, whr th n to limit momnt in rlati pric i l pronounc. Th gr o macroconomic olatility n to iturb an inoicing tatu quo or tra in mor homognou prouct woul n to b xcptionnaly larg. Thi rult upport th inrtia an thic mart xtrnaliti argu by Krugman an by Ry. But, importantly, our thortical priction i that -- n within a country whr all conomic agnt ac th am gr o macroconomic olatility-- irnt proucr will ma irnt inoic currncy choic. II. Th proit unction W aum that an xporting irm ha to pot a pric or it goo bor nowing th ralization o ariou hoc acting th conomy. Th xportr prouc a bran z, i locat in country, an ll hr goo to th tination country. Th xportr prouc goo uing a tchnology with craing rturn to cal: Y 0 < ( z) [ H ( z) ] whr Y ( z) i th output o z, ( z) paramtr. Th irm ac th ollowing man in country : Y ( z) () H i th labor input, an i th rturn to cal P P ( z) - C () 5 By contrat Drux, Engl an Storgaar (004) ri th optimal inoicing in a gnral quilibrium mol. Whil thi allow or a complt olution, thir analyi i ocu on th rol o macroconomic olatility, an o not inclu any rol or inrtia tmming rom th ominant rol o a currncy in th pat. 6

9 whr C i th total man or bran o th rlant ctor in country, ( z) P i th pric, in country currncy, o th bran z prouc in country, an P i th pric inx, in country currncy, acro all bran o th rlant ctor ol in country. > i th laticity o ubtitution btwn th ariou bran. () how that th man or a pciic bran rlct it pric, rlati to th pric o othr bran in th ctor, an th trngth o orall man. Th xportr proucing bran z t it pric in currncy bor th ralization o th hoc acting th conomy. W not th pric by P ( z). Th currncy o inoicing can b th currncy o th country in which th xportr i locat (), th currncy o th country o tination (), a thir hicl currncy (), or a combination o th thr currnci. Whil coniring inoicing in a bat o irnt currnci may appar o, it proi a impl way to gnrat a partial pathrough o xchang rat luctuation to conumr pric, ollowing Cortti an Pnti (00). Th prnc o partial xchang rat pa-through i a irabl atur in light o th mpirical inc [Campa an Golbrg (004, 00), Franl, Parly an Wi (004), Anrton (003)]. Th xportr t it pric in currncy to maximiz xpct proit: Π whr ( z ) ED S P ( z) S P S P ( z) C W ( ) S P S P S i th xchang rat btwn currncy an currncy, in trm o unit o currncy pr unit o currncy o that an incra corrpon to a prciation o currncy. D i th tat-pciic icount actor at which proit ar aluat, 6 an W i th nominal wag. With it pric t in currncy, th unit rnu or th xportr ( z) C (3) 6 W conir that th irm i own by agnt in th xporting country, o proit ar icount uing th marginal utility o incom or th agnt. Thi i on without lo o gnrality: whil a rint o anothr country woul alu proit atr conrting thm in hr own currncy, thi ha no impact on th optimal inoicing ciion that i th ocu o th papr. All w rquir i that th ownr trat hr marginal utility o incom a inpnnt rom th proit o a particular irm, in a imilar way a h trat th conumr pric inx a inpnnt rom th pric t by a particular irm. 7

10 in currncy i S P ( z) - tination country i [ S ] S P ( z). Similarly, th pric in currncy pai by conumr in th. Following tp tail in th Appnix, w ol th proucr problm by xpring th proit unction (3) in trm o quaratic approximation aroun a nontochatic tay tat. Dnoting log iation rom th tay tat by lowr ca lttr x ln X ln X ) w obtain: ( π q ( ) ( ) ( ) E E q p [ q ] E[ q ] Eq w c whr w ignor trm that ar inpnnt o th inoicing ciion. Th trm q in (5) i th pric o bran z in th tination country, rlati to th pric o th compting bran in that country. Following hoc, th pric o bran z t in currncy o not mo. Th pric pai by a conumr in th tination currncy i thn rin by th xchang rat btwn currncy an currncy : Eq c (5) (4), with an apprciation o currncy i-à-i currncy (i.. < 0 ) rucing th pric pai by th conumr. Th arag pric pai by th conumr or compting bran, in currncy, i gin by th inutry-wi inx: p. An incra in th rlati pric ( q > 0 ) inicat that th irm proucing bran z loo comptitin, laing conumr in th tination country to hit thir purcha towar othr bran. Th magnitu o thi hit i rin by th laticity o ubtitution btwn bran,. Intuitily, th ariou trm o (4) rlct th co-momnt o th marginal rnu an marginal cot with man. 7 Th impact o xchang rat momnt on th marginal rnu i gin by th trm q, which rlct th luctuation in th quantity ol bcau o momnt in comptitin, a wll a th luctuation in th xportr-currncy rnu o a gin al, tmming rom momnt in th xchang rat btwn th xportr an inoicing currnci. (4) how that proitability i incra whn xchang rat luctuation la to a high marginal rnu in th tat o 8

11 natur whn man i trong in th tination country (i.. [ q ] c > 0 E ). Marginal cot ar incraing in th wag an th trngth o man, th latr apct rlcting craing rturn to cal. Proitability i highr whn th xportr loo comptitin in th tat o natur whr wag or man ar high ( Eq w 0, or Eq c > 0 ). Intuitily, th ruc comptitin hit man away > rom th xportr, paring hr rom haing to prouc at a high cot. II. Optimal inoicing Th xportr choo th currncy in which hr goo ar inoic to maximiz (4). Spciically, hr choic i captur by th xchang rat btwn th currncy o hr country an th currncy o inoicing,, in th proit (4) an th rlati pric (5). Th xportr rgar all th othr ariabl in (4)-(5), uch a th man c, wag aggrgat pric w, an p an xchang rat a inpnnt rom hr inoicing ciion. W o not rtrict th xportr to inoic ntirly in ithr currncy, or. Inta, w mol th inoicing ciion a a choic o wight o th thr aailabl currnci in th inoicing currncy bat. Spciically, th wight o currnci an in th inoicing o xport to country ar an rpctily, with th wight o currncy bing. Th xchang rat btwn th xportr' currncy,, an th compoit currncy in which h inoic,, i thn a linar combination o th xchang rat btwn currncy an th othr two currnci, an, with wight rlcting th compoition o th inoicing bat: Pricing in th proucr' currncy (PCP) corrpon to 0, whil pricing in th cutomr' currncy (LCP) corrpon to, 0, an pricing in hicl currncy (VCP) i th ca whr 0,. A icu abo, th rlati pric btwn bran z an th compting bran (5) play a y rol in th inoicing ciion. W now turn to th nitiity o th pric (6) 7 A mor tail icuion can b oun in th Appnix. 9

12 inx o compting bran, p, to xchang rat momnt. Som bran ar inoic in currncy, o th pric pai by th conumr or th bran i unact by xchang rat momnt. Othr bran ar inoic in currncy, an th conumr pric in currncy mo with th xchang rat btwn th two currnci,, with conumr paying a highr pric whn currncy apprciat (i. < 0 ). A inal t o bran ar inoic in currncy, o th pric pai by conumr i highr whn currncy apprciat (i.. < 0 ). W not th har o compting bran inoic in currncy by η, an th har inoic in currncy an by η an rpctily. 8 Th impact o xchang rat momnt on pric inx o compting bran i thn: p ( ) ( η ) η (7) η η Combining (6) an (7), w writ th rlati pric (5) a: η q ( η ) ( η ) (8) (8) how that a ull tabilization o th rlati pric rquir th xportr to choo wight on th irnt currnci that xactly corrpon to thir har in th inutry wi pric inx: η, η. Th irm choo th inoicing wight proit (4), unr th contraint that, an an to maximiz th xpct o not all outi th [0,] intral. For a conci illutration o th trminant o th optimal wight, w ocu on an intrior olution whr both wight ar gin by tting th irt riati o (4) to zro. Following tp tail in th Appnix w obtain: whr: Ωη Ωη Ω ( Ω) ρ( m, ) ( Ω) ρ( m, ) (9) (0) ( Ω) Ωη ( Ω) [ ρ( m, ) ρ( m, )] () ( ), m w c ( ) 8 Th thr har um to on. 0

13 Th trm m in (9)-() rlct th inlunc o xognou actor on th irm marginal cot. Momnt in wag tranlat irctly into momnt in th marginal cot. Fluctuation in man alo act th cot. Bcau o craing rturn to cal, a prcnt incra in man rquir a / prcnt incra in th labor input, hnc a / prcnt incra in cot, holing th wag contant. Th incra in man alo la to a prcnt incra in rnu, holing th pric contant. Th nt incra in th marginal cot i thn / ( )/ Th trm ( ) ) marginal cot, prcnt. ρ in (9)-() captur th nitiity o th m, to th xchang rat an. Spciically, th coicint o a rgrion o th marginal cot on th xchang rat ar ( m, ) ( m, ). ρ or ρ or, an Th intuiti intrprtation o th optimal inoicing (9)-() i that an xportr inoic in a currncy othr than hr own or two raon: hring an hging. Inoicing in th xportr currncy ha th aantag o ully tabilizing th xportr marginal rnu, a h rci a gin amount o hr own currncy or ach unit ol. Thi ull tabilization ( ) i not ncarily an optimal choic howr, or two raon. Th irt raon or iating rom a ull inoicing in th xportr currncy rlct a hring moti, captur by th trm Ω an Ω in (9)-(0). Th xportr optimally limit th momnt o hr rlati pric by chooing an inoicing tratgy clo to that o it comptitor. For intanc, th xportr put a highr wight o inoicing in th tination currncy,, whn hr comptitor inoic a highr har o thir own al in that currncy, η. A imilar motiation hol or inoicing in th hicl currncy. Th con raon captur a hging moti, not by th trm ( Ω ) ρ ( m, ) an ( Ω) ρ( m, ) η in (9)-(0). Th xportr want to choo an inoicing tratgy that limit th impact o luctuation in marginal cot on hr proit. I h inoic in th tination currncy,, a prciation o hr currncy i-à-i th tination currncy ( > 0) incra th xportr rnu, in hr own currncy, rom η

14 ach unit ol. I prciation o th xchang rat tn to b aociat with incra in marginal cot, i.. ρ ( ) 0 m, >, inoicing in th tination currncy proi an hg a marginal rnu an marginal cot thn mo in tp. A imilar logic appli to th hicl currncy. Equation (9)-(0) how that th xtnt o inoicing in th tination an hicl currnci rlct th hring an hging coniration. Intrtingly, thr i nothing pcial about inoicing in th currncy o th tination country, a it i rin by th am coniration a inoicing in any hicl currncy. Th rlati wight on th hring imnion in (9)-() i gin by th trm Ω, which olly rlct th tructural paramtr o th mol, namly th laticity o ubtitution btwn goo,, an th gr o rturn to cal,. Th hring imnion i mor pronounc ( Ω i larg) in inutri whr goo ar mor ubtitutabl ( i larg), a momnt in rlati pric thn la to larg luctuation in quantiti ol. Th ct i alo trongr th mor th tchnology xhibit craing rturn to cal ( i mall), bcau luctuation in output gnrat larg momnt in marginal cot. Our mol inicat that th hring moti can ominat inoicing unr raonabl paramtr. Chart how th combination o (horizontal axi) an (rtical axi) laing to a mall wight o th hring moti ( Ω 0.), a mium wight ( Ω 0.5) an a larg wight ( Ω 0.8). Coniring alu o 0.65 an 6, which ar raonabl paramtr, 9 la to to a wight on th hring moti o In th limit ca o prct comptition ( ), only th hring moti rmain a th irm n to ully tabiliz it rlati pric: lim Ω lim η lim η lim η Thi atur o th olution uggt important itinction in inoicing choic acro typ o inutri. Th inoicing o xport in inutri that ar highly irntiat i rlatily mor rponi to th pattrn o olatility in macro-conomic 9 In a mol with a contant rturn to cal tchnology in labor an a ix actor, uch a capital, a labor har o 65 % i a tanar pciication. A alu o 6 or th laticity o ubtitution corrpon to a 0% marup. Elaticiti o thi magnitu, or n highr, ar a common paramtrization.

15 ariabl, uch a wag an man. By contrat, in inutri that prouc a mor homognou goo, irm will inoic in a bat o currnci clo to that o thir comptitor. Chart : Wight o th hring imnion 5 Ω 0.8 Subtitutability ( ) 0 5 6, > Ω 0.76 Ω 0.5 Ω Dgr o conomi o cal ( ) Anothr apct alo point to a morat rol or co-momnt o th xchang rat with marginal cot, rlati to hring. Th trm ρ ( m, ) an ( m, ) ρ in (9)- () ar ntially ratio btwn th coarianc o th xchang rat with wag an man, an th arianc o th xchang rat. I th magnitu o xchang rat luctuation i much largr than th magnitu o thir co-momnt with othr ariabl, th nominator in th trm ρ ( m, ) an ( m, ) ρ ar rlatily larg, hnc th trm thml rlatily mall. I xchang rat ar conirably mor olatil than man an wag unamntal, hring in inoicing currncy lction will ominat th rol o th unamntal. A tr by Engl (003), th actor riing th choic o inoicing currncy whn pric ar ticy ar th am riing th optimal gr o xchang rat pathrough unr lxibl pric. Whil h ocu on limit ca o inoicing, with pric t ithr in th proucr or conumr currnci, w can how that th optimal inoicing wight (9)-(0) ar qual to th optimal gr o pa-through unr lxibl pric. 3

16 II.3 A implii mol Th optimal inoicing in (9)-() how that thr i no impl rlation btwn th olatility o a particular xchang rat an th choic o inoicing. Inta, th comomnt btwn xchang rat an marginal cot play a cntral rol. To put mor tructur in th tup, w mol th xchang rat btwn currncy an currncy a rin by unamntal actor (uch a montary policy) in country an in country. W not th actor by an rpctily. Rcognizing th omtim iicult rconciliation btwn luctuation in unamntal an tho in xchang rat, w mol th xchang rat a alo rin by two noi trm, not by an rpctily. 0 Th xchang rat btwn currncy an currncy i imilar, an w writ:, W aum that th wag i rin by th unamntal in th xporting country, whil man in th tination mart ollow th unamntal in th importing country: w, c γ, γ 0, γ 0 γ w c w c whr γ w an γ c rlct th nitiity o wag an man to th rlant unamntal. Th prnc o noi in th xchang rat rlation allow or xchang rat to ract to ariabl which ha no ct on contmporanou wag an man. Following tp tail in th Appnix, w a how chang in th olatility o th ariou unamntal impact th inoicing. Th rult ar ummariz in Tabl, whr ( x ) E( ) : x, 0 Franl an Ro (995) how that olatility o inutrializ countri xchang rat i an orr o magnitu highr than olatility in unamntal. Engl an Wt (004) proi an intrting rh prpcti on thi iu by trating xchang rat a rlcti o a icount tram o xpct utur unamntal. Th aumption ar conitnt with th ct o montary hoc in a gnral quilibrium mol. 4

17 Tabl : impact o unamntal olatility Incra in th olatility o unamntal Impact on ( ) ( ) ( ) Tabl how that an incra in th olatility o unamntal in on country la xportr to ruc th wight o it currncy in thir inoicing ciion, an incra th rol o th othr two currnci. Th tail xprion in th Appnix alo how that th hit i mor pronounc towar th lat olatil currncy. For xampl, i ( ) > ( ), an incra in ( ) incra. ruc, an incra by mor than it Whil th nitiity o th optimal inoicing to th olatility o unamntal i unambiguou an intuiti, a hown by tabl, th nitiity to th olatility o th noi trm i mor complx. Th Appnix how that in gnral th ct i ambiguou. Th only clar pattrn i that a highr olatility o th noi trm in th hicl country, ( ), ha th am impact than a highr olatility o th unamntal, ( ). Thi mol t th tag or mpirical analyi o th trminant o inoic currncy choic acro proucr an acro countri. W bgin by xpoiting act on th currncy inoicing o intrnational tra. W thn xamin inutry-pciic choic an th rol o macroconomic ariability in inoicing outcom. III. Th u o ollar an othr currnci in intrnational tra III. Oriw. Dtail on th currncy inoicing o intrnational tra tranaction ar har to com by. Som rcnt but icrt act ar gin in papr motiat by iniiual countri or rgion, a in Swih inoicing by Fribrg (996), Canaian inoicing by 5

18 Donnnl an Haug (003), an Japan by Oi, Otani, an Shirota (004). Einc ha bcom aailabl or uro-ara an accion countri, in part triggr by th ant o th uro an ort to trac it aoption in goo mart an inancial mart (ECB 00, 003). No ingl ata ourc compil th inormation rom th tui, or rom th ariou icrt ourc o inormation on country inoicing o intrnational tra tranaction. Thi ction o th papr proi cro country, cro inutry an om intrtmporal ata. Th twnty-our countri or which w ha collct inoicing inormation ar: th Unit Stat, th Unit Kingom, ight uro-ara countri (Franc, Grmany, Italy, Blgium, Luxmbourg, Italy, Spain, an Portugal), nin Europan Union accion countri (Bulgaria, Cypru, Czch Rpublic, Etonia, Hungary, Latia, Polan, Sloaia, an Slonia), plu Japan, Kora, Malayia, Thailan, an Autralia. Th ata aailability an ourc or our tuy ar ummariz in Appnix Tabl. 3 Th aailability inormation ari trmnouly acro countri in trm o tail an tim hitori. Rcntly, ECB ort ha ma aailabl rich cro-country ata within Europ. Th Unit Kingom an Autralia ha ry tail inormation on currncy inoicing o tra tranaction o irnt commoiti or with irnt country partnr. Within Aia, tail ata i aailabl or both Japan an Kora. Data or th Unit Stat i rawn rom Cutom inormation u in contructing intrnational pric ri. 4 Chart how th xtnt to which ach country aggrgat xport ar inoic in th xportr currncy, corrponing to th notation aggrgat acro xportr rom th mol. Th mallr countri rprnt in thi chart typically u thir own Btwn 999 through 00Q3, th Europan Commiion (Quartrly Riw o th U o th Euro) publih quartrly inormation on th intrnational tranaction o uro ara irm. Thi publication ocu on th tranition prio o th uro, an maur th u o th uro compar with both national currnci (DM, Fr, tc) an th orign currnci. 3 A Appnix Tabl tail, om o th ata ar unpublih but ma aailabl to u or thi wor. W ar gratul to th agnci that proi thi inormation an appro our u an imination. Th tabl alo how that irnt mtho ha bn u by countri in contructing th ata. Looing acro countri, in om ca w cannot initly tat whthr th ata captur th currncy o tranaction inoicing or currncy o tranaction ttlmnt. 4 For th Unit Stat, th BEA th Intrnational Pric Program collct ata on currncy olly to conrt pric into U.S. Dollar or th purpo o proucing pric inx. Th U.S. Cutom Sric collct th ata on th alu o import an xport, but on t p ata on th currncy in which tra 6

19 currncy on l than 0 prcnt o thir xport tranaction. In, a numbr o mall countri not hown in th chart (but inicat in th ootnot) o not n rport tail o u o thir own currncy in intrnational tra tranaction. Th uro i u a th inoic currncy on 40 to 50 prcnt o (xtra uro ara) xport by uro ara countri. Th Koran won i lom u, th yn i u on about a thir o Japan xport, an th poun trling on about hal o UK xport. Th Unit Stat i th clar xcption, inoicing mor than 90 prcnt o xport in U.S. ollar. Broaly imilar pattrn in country import, xcpt that th importing country currncy i typically l otn u in th import tranaction, upporting Graman Law. A Shar o Total Export (in prcnt) Chart : Export Inoic in Exportr Hom Currncy Autralia Blgium# Czch Rpublic Franc# Grmany# Grc# Italy Japan Kora Latia Luxmbourg# Exportr Country Malayia Portugal# Spain# Thailan Unit Kingom Unit Stat # Extra-uro tra only. For Kora, tra ata or "Othr currnci" (nt o US$, yn, uro, UK poun trling) u a uppr boun timat o Koran Won har. Countri or which w o not ha pciic ata or thi chart ar: Bulgaria, Cypru, Etonia, Hungary, Polan, Sloaia, Slonia. Inutry tail on currncy inoicing ar irctly aailabl or our o th countri in our ataba: Autralia, Japan, th Unit Kingom, an th Unit Stat. For ach country, th inutri or which inoicing ata ar aailabl ar compil into on o thr broa group: irntiat prouct, goo tra on organiz xchang, an rrnc pric goo. Th aignmnt o inutri to group ollow th Rauch (999) paintaing claiication o commoiti at th thr an our-igit i conuct. A con caat i that th ata thy collct i a ampl o orall tra rathr than ry tranaction. 7

20 SITC ll. In th Rauch inic, an organiz xchang goo i anything that ha an ort mart (i.. prciou mtal). A rrnc pric goo i a homognou goo that nonthl o not ha a ubtantial nough olum to ha an "oicial" mart (.g. obcur chmical prouct), but that bcau o it homognity o ha "rrnc" pric that ar publih in tra magazin. Th thr broa catgori roughly corrpon to cla o comptiti pricing o goo, with organiz xchang tra goo tho that ar mot highly ubtitutabl with imilar catgori o orign prouc goo, an th irntiat prouct lat ubtitutabl. Chart 3 proi uggti inc that th xtnt o inoicing in th xportr currncy i rlat to th amount o tranaction on rrnc pric or organiz xchang goo. It inicat th har o xport inoic in th xportr currncy or xport o irntiat goo (column n ), rrnc-pric goo (column r ) an goo tra on an organiz xchang (column w ) or Autralia, Japan an th Unit Kingom. It how that th xtnt o pricing in th xportr currncy i highr or irntiat prouct, th pattrn bing mot pronounc or Autralia. With th xcption o th Unit Stat, w obr that th xportr currncy i mor rquntly u on tranaction in irntiat goo than in tranaction on rrnc pric or organiz xchang goo. Chart 3: Hom Currncy U in Inoicing o Export, by Typ o Inutry n irntiat prouct r rrnc pric w organiz xchang n r prcnt inoic in hom currncy n r w n r Autralia Japan UK USA Not: Data or Autralia or 00, or 0 SITC -igit inutry catgori, coring 96.5% o DOTS-rport total import. Data or Japan or 999, or 6 SITC -igit inutry catgor, coring 95.% o DOTS-rport total 8 import. Data or UK or 00, or 0 SITC -igit inutry catgori, coring 0.4% o DOTS-rport total import. Data or USA or 00, or 5 n-u catgori, coring 95.% o DOTS-rport total import. n r w

21 III.. Explaining th U.S. Dollar a a Vhicl Currncy Tabl rport th u o th U.S. ollar in th inoicing o xport an import in our ampl. Mor than 95 prcnt o U.S. xport an 85 prcnt o U.S. import wr inoic in ollar in arly 003. Th u o th ollar in U.S. xport an import tranaction pn on th traing partnr. 5 U.S. xport to an import rom Latin Amrica, China, Mxico, an mot mall countri, ar almot xcluily inoic in U.S. ollar. By contrat, orign currnci appar mor prominntly in th inoicing o U.S. import rom th Europan Union, th Unit Kingom, an Japan. Whil th pciic har aign to orign currnci i not alway conitnt acro rporting partnr countri, rom th prpcti o U.S. ata about 5 prcnt o U.S. import rom Grmany (in alu trm) ar uro inoic; 4 prcnt o U.S. import rom th UK ar inoic in poun trling, whil prcnt o U.S. import rom Japan ar in Japan yn. U.S. import rom th rt o th worl ar orwhlmingly inoic in U.S. ollar. Turning to othr countri, approximatly on thir o th xport o mot uro ara countri (to countri outi o th uro ara) ar inoic in ollar. Clo to 40 prcnt o comparabl uro ara import ar inoic in ollar. Looing acro countri, th U.S. ollar i u intnily in U.K. tra tranaction, on 6 prcnt o U.K. total xport an 37 prcnt o U.K. import. Th EU accion countri ar mix in th xtnt to which ollar ar u in inoicing thir intrnational tra tranaction. Currntly, ollar u on inoicing i otn lowr than incinc o u by uro-ara countri. A w will tail latr, th pattrn ar tarly irnt than in th rcnt pat or th accion countri. 5 Th xtnt to which th ollar i u in bilatral tra tranaction i otn not intical acro th two parti rporting currncy u in tra tranaction. Gin th ampling limitation in th U.S.-ourc ata, w r to orign ourc ata or currncy har whn that orign ata i aailabl. 9

22 Tabl : U.S. Dollar U in th Export an Import Inoicing o 4 Countri Inoicing Obration* US $ Shar in Export Inoicing US $ Shar in Import Inoicing Unit Stat Aia Japan Kora Malayia Thailan Autralia Europan Union Blgium# Franc# Grmany# Grc# Italy# Luxmbourg# Portugal# Spain# Unit EU-Accion Bulgaria Cypru Czch Etonia Hungary Latia Polan Sloaia Slonia * Latt Obration ar annual xcpt or: Japan January 00, Grmany & Grmany # 00Q3, Etonia Jan-Aug 003. Unit Stat ata ar or 003Q. Malayia an Thailan igur ar or orall tra an ar not bron own by xport or import. # Inoicing ata rr only to th inoicing o xtra uro-ara tra. For th U.K. thi igur rr to xtra EU-4 tra. By contrat, th ollar rmain a ominant currncy in th inoicing o both xport an import by countri outi o Europ. Both Kora an Thailan u th ollar in inoicing mor than 80 prcnt o thir xport an import tranaction. For Japan, Autralia, an Malayia, th ollar i u in mor than 50 prcnt o tra tranaction. 0

23 00 Chart 4: Vhicl Currncy U o th U.S. Dollar in Intrnational Export Tranaction Country' Export to th US a a har o Total Country Export, % Portugal Japan 45* Blgium Grman Franc Italy UK Luxmbourg Hungary Spai Slonia Czch Bulgaria Latia Etoni Sloaia Polan Cypru Malayia Autralia Grc Kora Thailan US Dollar Inoicing Shar in Country Export, % Sourc: DOTS an ariou national ourc Euro-ara country ata, with th xcption o Italy ata, rr to xtra-uro ara tra an inoicing To gain prpcti on what portion o th ollar inoicing rult might b irctly attributabl to country tranaction with th Unit Stat an what portion i a pur hicl currncy rol, in Chart 4 w contrat th ollar inoicing har in xport tranaction o ach country (horizontal axi) with th har o th Unit Stat a a irct rcipint o a country xport (rtical axi). 6 Unr an xtrm aumption o complt ollar inoicing o tra with th Unit Stat an no hicl currncy rol or th ollar, th inicat point woul li along th iagonal o thi chart. All ata point ar to th right o th 45 gr lin, prnting trong (an unrtat) inicati inc o ollar u a a hicl currncy. Thi hicl currncy rol appar particularly trong or tra tranaction by Kora, Thailan, Autralia, th Unit Kingom, an Grc, among othr. Orall th pralnc o ollar inoicing o a country xport an import bunl i ar gratr than what woul b xpct purly on th bai o th irct importanc o th U.S. a a irct tra countrparty or any o th countri. 6 W ha on a imilar analyi or country import rom th Unit Stat, with broaly imilar ining.

24 Anothr ry complling mpirical ining ari rom our application o th Rauch inic to xport ata in orr to xplain th portion o ach country xport that i inoic in ollar, without th Unit Stat a a countrparty, an in organiz xchang tra or rrnc pric goo. 7 For ach country, w contruct maur o th har o total xport o that country (in tra that xclu th Unit Stat) that ar in organiz xchang tra prouct, or rrnc pric prouct. Th har o th tranaction in country xport tranaction ar hown in Tabl 3. Among th countri in our tabl, Autralia ha th hight har o xchang tra an rrnc pric goo in it xport, wighing at 66 prcnt o th xport to countri othr than th Unit Stat. Grc, Bulgaria, an Cypru all ha thi typ o xport har at about 40 prcnt. Japan an Grmany ha low har o th typ o goo, on th orr o 5 prcnt o thir non-u.s. xport. Viually, Chart 5 buil on Chart 4. Th horizontal axi how th har o xport inoic in ollar, whil th rtical axi how th total har o xport that ar ithr going to th Unit Stat, or conit o rrnc pric goo going to tination othr that th U.S. Whil th rol o th ollar xc th rol o th U.S. a a tination mart, a hown in Chart 4, th pattrn hown in chart 5 align mor cloly with th 45 gr lin. Spciically, th rol o th ollar in inoicing i in lin with th rol o th U.S. a a mart an th rol o xport o rrnc pric goo to countri othr than th Unit Stat. Conitnt with th tail ata aailabl rom Autralia, th Unit Kingom, an Japan, acro countri th commoity-typ tranaction appar to xplain th wipra hicl currncy u o th ollar in mot o th countri (outi o th U.S.) or which w ha compil tra inoicing ata. Whil Chart 5 bring u clor to a complt unrtaning o th rol o th ollar in intrnational tra, two country group tan out. Firt, th rol o th ollar or Eatrn Europan countri i mallr than what thir pattr o xport uggt. Thi lily rlct th prominnt rol o th uro ara a a tination mart. An xportr rom Eatrn Europ lling a non-irntiat goo, uch a chmical, in th uro ara put a high wight on ping hi pric in lin with that o hi comptitor. I a ubtantial har o th comptitor pric in uro, bcau or intanc thy ar irm 7 W o an analogou xrci alo on th import i or ach country, with qualitatily imilar ining.

25 locat in th uro ara, thn th xportr will alo inoic in uro. Th con outlir group i ma o countri in South-Eat Aia or which th xport to th U.S. an in rrnc-pric goo till all hort o accounting or th rol o th ollar a an inoicing currncy. Thi poibly rlct a ownwar bia in th maur rol o th U.S. a a traing partnr, bcau o tra low to th U.S. that go through othr countri. Conir th ca o a Thai xportr lling componnt to a proucr in Malayia or ambly or inal goo tin to th U.S. Whil th tra low rom Thailan i not going irctly to th U.S., it i part o an xport rom th rgion to th U.S. Chart 5 Vhicl currncy u o th ollar an "commoity " typ xport Country' Export to th US Shar plu RW Goo Shar o Total Country Export % Bulgaria Cypru UK Franc Etonia Spain Grmany Luxmbourg Sloaia Italy Polan Slonia Czch Rpublic Hungary 45* Blgium Portugal Latia US Dollar Inoicing Shar in Country Export, % Sourc: DOTS an ariou national ourc Euro-ara country ata, with th xcption o Italy ata, rr to xtra-uro ara tra an inoicing Japan Autralia Grc Malayia Thailan Kora 3

26 Tabl 3: Organiz Exchang an Rrnc Pric Goo in Export an Import Shar in Export Tranaction Shar in Import Tranaction Dat All xport Nt - U.S. All import Nt-U.S. Unit Stat Aia Japan Kora Malayia Thailan Autralia Euro-Ara Countri Blgium# Franc# Grmany# Italy Grc# Luxmbourg# Portugal# Spain# Unit Kingom EU-Accion Bulgaria Cypru Czch Etonia Hungary Latia Polan Sloaia Slonia III.3 Economtric o Hring ru Macroconomic Variability Our mol mphaiz that,, an ar nognou to both inutry tructur an macro-conomic olatility. Th hring moti in inoicing i a mor important coniration or walraian goo. Th macroconomic olatility unrlying th hging moti mattr mor or tra in irntiat prouct, with th lilihoo o a country currncy bing chon or inoicing intrnational tra tranaction 4

27 inrly rlat to th olatility o th country unamntal. In thi ction, w proi an conomtric analogu o th priou ction graphic. W alo rlat th inoicing unxplain by tra with th U.S. or walraian xport to th olatility o aggrgat man in th xporting country ru, or xampl, th Unit Stat mart. 8 Th rgrion ta a panl ormat uing all countri or which w ha inoicing ata, xcpt th Unit Stat. Two pnnt ariabl ar u in th rgrion, ) th har o a country xport that ar inoic in ollar, or ) th har o a country xport that ar inoic in th hom country currncy. 9 Th xplanatory ariabl ar th har o th U.S. a a tination mart or xport, th har o a country xport (xcluing tho to th U.S.) that ar in Rauch-typ walraian goo (xchang tra plu organiz xchang tra), an hom country aggrgat man olatility. Th rgrion or inoicing in hom currnci alo a a ariabl to rlct th har o a country tra with th uro ara. Th rult o th rgrion ar prnt blow in Tabl 4. In om pciication, w tt whthr uro-ara countri ha irnt inoicing nitiiti than countri that ha not yt aopt th uro. 8 W ha ri an xplicit mapping rom th thortical pciication to a rgrion pciication unr th aumption that thr ar two typ o goo in th worl, walraian ru irntiat. Thi xplicit ormulation alo aum that, or a particular inutry, th arag har o inoicing in th xportr currncy i a wight arag acro th choic with rpct to ach tra partnr tination, with th wight corrponing to th importanc o ach partnr a an xport mart. W ha xprimnt with pciication o tra-partnr wight olatiliti a xplanatory ariabl, but ha not gottn aitional inight rom tho pciication. 9 A w countri o not rport har o xport that ar inoic in thir hom currncy (Bulgaria, Cypru, Etonia, Hungary, Polan, Sloaia an Slonia, Appnix Tabl or mor tail). Th countir ar not inclu in th rgrion or th hom currncy inoicing har o xport, but ar inclu in th rgrion or th ollar inoicing har. 5

28 Tabl 4 Dtrminant o th Currncy U in Inoicing Country Export Tranaction Dtrminant o U.S. Dollar Shar in Inoicing Rgrion# *** contant (6.7) Export har to th Unit Stat.96*** (0.54) Euro ara ummy * Export har to th -.57** Unit Stat (0.57) Walraian har o xport to countri othr than th US Euro ara ummy *Walraian har o xport to countri othr than US Hom country olatility o ral aggrgat man Euro ara ummy * Hom country olatility o ral aggrgat man (9.63.7*** (0.43) -0.4 (0.85) 0.95*** (0.5) -0.8* (0.39) -.4 (.35).65*** (0.58) 0.60** (0.7) 0.05 (0.06) -9.8 (0.95).3*** (0.48) (.0) 0.97*** (0.8) -0.94* (0.49) 0.0 (0.05) 8. (6.3) # obration aj.r Dtrminant o Hom Currncy Shar in Inoicing Export Rgrion# contant (.7) Export har to th Unit Stat 0.5 (0.56) Euro ara ummy * Export har to th.3*** Unit Stat (0.5) Export har to Euro Ara 0.8 (0.4) Walraian har o xport to countri othr than th US Euro ara ummy * Walraian har o xport to countri othr than th US Hom country olatility o ral aggrgat man Euro ara ummy * Hom country olatility o ral aggrgat man (.9) 0.69 (0.69).65** (.0) 0.6 (0.9) 0.0 (0.34) -0.3 (0.45) 49.9** (.5) (0.8) -0.7 (0.8) -0.5 (0.30) -0.95** (0.40) 8.5 (8.9) 0.49 (0.80).7* (.) 0.5 (0.3) 0.0 (0.39) -0.3 (0.59) (0.35) 5.5 (8.66) # obration aj.r Not: all rgrion inclu contant trm. ***, **, * tatitical igniicanc at 0, 5, prcnt ll. Stanar rror in parnth. 6

29 Th rgrion rult upport th argumnt o our thortical ction, an rconirm th mpirical obration rom Chart 4 an 5. Th rult or th ollar u in inoicing a rport in th top panl o Tabl 4 ar mot intrting. Rgrion inclu only th har o th U.S. in total xport, allowing or a irnt ct or uro-ara xportr. Thi actor alon xplain on thir o th cro country ariation in ollar u, with a highr ollar u in inoicing by countri that ar not in th uro-ara. Rgrion introuc alo conir th rol o xport o walraian goo to countri othr than th U.S. Th walraian goo trm xplain an aitional 5 prcnt o th cro-country ariation in ollar u in tra inoicing. Onc w account or th tra rol o th Unit Stat an th compoition o tra, w ha a goo inication o th xtnt to which a country will b uing ollar to inoic xport. Th rult o rgrion 3 an 4 how that th olatility o aggrgat man in th xporting country i not a tatitically igniicant contributor. It i important to not that thi ining i not ncarily a rutation o th potntial rol or macroconomic olatility trm in th inoicing ciion o proucr. A th U.S. aggrgat man olatility i low rlati to th olatility obr in mot countri in our ampl, a choic o inoicing in ollar ba on olatility coniration woul to a larg xtnt b captur by th contant trm. Nrthl, th contant i not tatitically igniicant, an th abnc o a rol or olatility prit n whn w itinguih btwn countri in th uro-ara, with a imilar olatility than th U.S., an othr. Thi point to a limit rol o olatility a a rir o inoicing. Th rgrion or th u o th hom currncy i prnt in th bottom panl o Tabl 4. 0 Th only tatitically igniicant rult ar that th countri in th uroara ar mor lily to inoic thir xport in th uro. Alo, highr omtic olatility ruc th u o th hom currncy. 0 Th rult xclu th countri that o not rport har o xport inoic in thir hom currncy (Bulgaria, Cypru, Etonia, Hungary, Polan, Sloaia an Slonia). 7

30 III.4 Prpcti or th intrnational rol o th ollar. Our analyi uggt that th prpcti or th utur rol o th ollar a an inoicing currncy ar rin both by th rol o th U.S. in intrnational tra, an by th importanc o worl tra in goo that tranact ia organiz xchang or ia rrnc pricing. Ba on annual ata 980 through 00, th U.S. har in total worl import luctuat btwn approximatly 5 an 0 prcnt, in rlation to th U.S. buin cycl. Alo cntrally important i th compoition o worl tra, an particularly th har o goo ar in inutri with high gr o prouct ubtitutability. A on rough maur o thi, Chart 6 how th har o worl tra in goo tra on organiz xchang or goo that ar rrnc pric (which w contruct uing th Rauch maur). Thi typ o tra ha bn clining taily a a har o worl tra or rcnt ca, conitnt with th rapi growth o tra in manuactur goo both a intrmiat componnt an a inal prouct. Th tar clin point to a tay clin in ollar inoicing o tra ia thi channl. Prcnt 50 Chart 6 Shar o Organiz Exchang an rrnc pric goo in Worl Tra Sourc: OECD RW Shar o Export RW Shar o Import 8

31 IV. Concluing Rmar Our analyi how that th ollar i trongly u on all tra tranaction with th Unit Stat, an on othr tranaction that ar primarily in goo that ar tra on organiz xchang or that ar rrnc pric. W ha hown that thi u o th ollar o not primarily pn on th xchang rat btwn th ollar an othr partnr currnci. Inta, th rol o th ollar a a tranaction currncy in intrnational tra ha lmnt o inutry hring an hytri, otn with a l cntral rol in inoicing or hging a aociat with arianc an coarianc among macroconomic unamntal. Our thortical an mpirical rult upport th typ o concluion rach in a rcnt Europan Cntral Ban rport Whil th xitnc o intrnational pricing tanar o not prclu, by itl, th u o anothr currncy or ttlmnt, th uro ara tra in nrgy an raw matrial will probably continu to b both inoic an ttl in U.S. ollar, a long a intrnational pric continu to b xpr in that currncy. ECB 00 pp.4-4. W argu that inutri with highly ubtitutabl goo ha a trong incnti to hr in thir choic o inoicing currncy. Thi typ o concluion i conitnt with th intuition o McKinnon (979), Krugman (980) an Ry (00). Th U.S. ollar appar to b important in th inoicing o worl tra both bcau th U.S. i an important conumr an proucr in worl mart, an bcau o it u in inoicing th many prouct that ar tra ia organiz xchang or uing rrnc pricing. 9

32 Rrnc: Anrton, Robrt Extra-uro Ara Manuacturing Import Pric an Exchang Rat Pa-Through. ECB woring papr no. 9. Bacchtta, Philipp an Eric anwincoop. 00. A Thory o th Currncy Dnomination o Intrnational Tra. NBER woring papr no Campa, Jo an Lina Golbrg. 00. Exchang Rat Pa-Through into Import Pric. NBER woring papr Sptmbr 004 riion aailabl. Cortti, Giancarlo, an Paolo Pnti. 00. Intrnational Dimnion o Optimal Montary Policy. NBER woring papr no Drux, Michal an Charl Engl. 00. Enognou Currncy o Pric Stting in a Dynamic Opn Economy Mol. NBER woring papr no Drux, Michal, Charl Engl, Storgaar. 004 Enognou Exchang Rat Pa- Through whn Nominal Pric ar t in Aanc. Journal o Intrnational Economic, Vol. 63, no., pp Donnnl, Shabtai an Alr Haug "Currncy Inoicing in Intrnational Tra: An Empirical Intigation." Riw o Intrnational Economic, Vol., pp Donnnl, Shabtai an Alr Haug. 00. "Currncy Inoicing in U.S. Import" mimo. Engl, Charl an Knnth Wt Exchang Rat an Funamntal. NBER woring papr no Engl, Charl, 003. On th Rlationhip btwn Pa-Through an Sticy Nominal Pric, mimo. Europan Cntral Ban, 00. Riw o th Intrnational Rol o th Euro. Fribrg, Richar. 988 "In which Currncy Shoul Exportr St thir Pric?" Journal o Intrnational Economic, Vol. 45, No., pp Gioannini, Albrto Exchang Rat an Tra Goo Pric. Journal o Intrnational Economic, Vol.4, pp Graman, S A Funamntal Symmtry in Intrnational Paymnt. Journal o Intrnational Economic, Vol. 3, pp

33 Krugman, Paul Vhicl Currnci an th Stuctur o Intrnational Exchang, Journal o Mony, Crit an Baning, Vol. pp McKinnon, Ronal Mony in Intrnational Exchang: Th Conrtibl Currncy Sytm (Oxor Unirity Pr). Murray, John, Jam Powll an Loui-Robrt Lalur Dollarization in Canaa: An Upat, Ban o Canaa Riw, Summr 003. Murray, John an Jam Powll. 00 Dollarization in Canaa: Th Buc Stop Thr, Ban o Canaa Tchnical Rport no. 90. Oi, Hiroyui, Aira Otani, an Toyoichiro Shirota Th Choic o Inoic Currncy in Intrnational Tra: Implication or th Intrnationalization o th Yn. Montary an Economic Stui (March) pp Paoa-Schioppa, T. 00. Th Euro go Eat. Lctur prnt at th 8 th Dubroni Economic conrnc, Rauch, Jam Ntwor ru Mart in Intrnational Tra. Journal o Intrnational Economic, Vol. 48 pp Ry, Hln. 00. "Intrnational Tra an Currncy Exchang" Riw o Economic Stui, Vol 68, pp Swoboa, Alxanr Vhicl Currnci an th Forign Exchang Mart: th Ca o th Dollar, in Robrt Z. Alibr, E., Th Intrnational Mart or Forign Exchang, Pragr Spcial Stui in Intrnational Economic an Dlopmnt, (Nw Yor: Frric A. Pragr, Publihr). Swoboa, Alxanr Th Euro-Dollar Mart: An Intrprtation, Eay in Intrnational Financ 64, Intrnational Financ Sction, Princton Unirity. Tala, Gorg Th Intrnational U o Currnci: Th U.S. Dollar an th Euro. IMF Financ an Dlopmnt, Vol. 35 no.. Till, Céric. 00. How Valuabl i Exchang Rat Flxibility? Optimal Montary Policy unr Sctoral Shoc. Fral Rr Ban o Nw Yor Sta Rport 47. Waltr, N. 00. Th Intrnational Dimnion o th Euro an th Path to th Euro or Enlargmnt Countri. Briing papr prpar or th Economic an Montary Aair Committ on th Europan Parliamnt, May 00. 3

34 Appnix A. Expanion o th proit unction pric P ( z) Maximizing th xpct proit (3) la to th ollowing rlation or th optimal : ( P ) ED ( S ) ( S ) ( P ) C ( )/ ( P ) ED W ( S ) ( S ) ( P ) ( C ) whr w ropp th z inx on P ( z) (A) a all irm ac th am problm an hnc choo th am pric. W xpr th proit unction (3) in trm o a quaratic xpanion aroun a trminitic tay tat. Following Till (00) th xpanion i ba on th ollowing rlation: a b a b X Y X Y ax by ( ax by) whr San Sri lttr not log iation rom th tay tat: Uing (A), th proit unction (3) i xpan a ollow: π ( ) ( ) ( ) whr ( Π Π )/ Π ( ) p E ( ) E p E E w [ ( ) p c ] Ew E E Ep Ec E E Ep Ec p c x ln X ln X. π w u th act that p i o orr an thror o not ntr th quar trm. Atr om algbra thi xprion bcom: π X [ q ] E[ q ] ( ) ( ) ( ) E q Eq w Eq c E c (A) 3

35 whr q i th rlati pric o bran z: q p (rcalling that p i prt hnc o not ntr th quar trm). choic: X E X i a trm inpnnt o th inoicing ( ) Ew [ ( E Ep ) Ec ] ( ) ( ) [ ] ( ) E c E w c ( ) ( ) ( ) E ( p ) Th irt bract on th right han i o (A.) captur th momnt in th S QP C rnu, [ ]. Th marginal rnu trm captur th impact o q xchang rat momnt, incluing through momnt in comptitin. Exchang rat momnt act th rlati pric o bran z i-à-i th compting bran, q, laing conumr to hit th allocation o thir purcha acro bran. In aition, with th pric ix in currncy, a prciation o currncy (i.. > 0 ) incra th amount o currncy rci by th xportr or ach unit ol abroa. Expct rnu or th xportr i highr whn xchang rat luctuation la to a high marginal rnu in th tat o natur whn man i trong (i.. [ q ] c > 0 W E ). Th con bract in (A.) rlct marginal cot coniration, [ Q ] ( C ). Th xpct cot i ruc whn th irm in country i not comptiti (i.. it rlati pric Q i high) prcily in th tat whr wag ar high ( Eq > 0 ), a th ruc comptitin par th irm rom haing to prouc w a lot at a high cot. Th xpct cot i alo lowr whn th irm i not comptiti in th tat whr man i high ( Eq > 0).Bcau o th craing rturn to cal, c luctuation in output ar cotly. Whn Eq > 0, a trong man i ot by a low c comptitin, a pattrn that tabiliz th xportr' marginal cot. 33

36 34 A. Optimal inoicing W ta th riati o (4) with rpct to th wight an : ( ) [ ] ( ) ( ) i i i i i i i i c q E w q E q Eq c q E q q E π, Uing quation (5) th riati o th xchang rat an rlati pric ar: q q Th riati o th proit unction ar thn: ( ) ( ) i i m q E π, whr m ummariz th impact o momnt in wag an man in th tination mart: c w m Subtituting or an ( ) ( ) q η η uing (5) w obtain: ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) m E E E m E E E η η π η η π whr not a rlation o proportionality. Not that tting th irt riati to zro nur a maximum (proi o cour that an,, o not all outi th [0,] intral), a th irct con riati ar ngati an th trminant o th matrix o con riati i poiti. Stting th irt riati to zro an oling th rulting ytm o two quation la to th ollowing wight on th ariou currnci: ( ) ( ) ( ) ( ) m m ρ η ρ η Ω Ω Ω Ω,,

37 35 whr: ( ) ( ) Ω an ( ) m, ρ an ( ) m, ρ ar th coicint obtain in a rgrion o m on th xchang rat an. A.3 A implr mol A.3. Driing actor W conir that ach country xprinc hoc in a unamntal ariabl, uch a th montary tanc. Wag in th xportr country an man in th tination mart ar rin olly by th unamntal in th xporting an tination country, rpctily. Th xchang rat btwn two countri ollow th irnc btwn th unamntal. W alo lt th xchang rat b rin by a noi ariabl,, in orr to captur th act that xchang rat ar mor olatil than wag an man. Th wag in th xporting country, th man in th tination country, an th xchang rat ar gin by: c w c w c w m c w,, 0 0,, γ γ γ γ γ γ whr γ w an γ c captur th nitiity o th wag an man to th unamntal. W conir that th ariou unamntal an noi ar all inpnnt rom ach othr, an not th arianc o unamntal an noi in country i by ( ) ( ) ( ) i i i i. Th componnt o (9)-() ar thn gin in tabl A.: Tabl A.: componnt o inoicing ( ) ( ) ( ) ( ) ( ) ( ) c w m γ γ ρ, ( ) ( ) ( ) ( ) ( ) c w m γ γ ρ, ( ) ( ) ( ) ( ) ( ) ( ) ( ) c w m m γ γ ρ ρ,, ( ) ( ) ( ) ( ) ( ) ( )

38 A.3. Impact o unamntal olatility Computing th riati o th ariou componnt o tabl A. with rpct to th olatility o unamntal in th xporting country, w obtain: ρ ( m, ) ( ) ( m, ) ( ) [ ρ( m, ) ρ( m, )] ( ) 0 ρ > > 0 < 0 Turning to th riati with rpct to th olatility o unamntal in th tination country w gt: ρ ( m, ) ( ) ( m, ) ( ) [ ρ( m, ) ρ( m, )] ( ) 0 ρ < > 0 > 0 Th riati with rpct to th olatility o unamntal in th hicl country ar: ρ ( m, ) ( ) ( m, ) ( ) [ ρ( m, ) ρ( m, )] ( ) 0 ρ > < 0 > 0 A.3.3 Impact o noi olatility Th riati o th ariou componnt o tabl A. with rpct to th olatility o th noi trm in th xporting country ar: ρ ( m, ) ( ) ( m, ) ( ) [ ρ( m, ) ρ( m, )] ( ) 0 ρ <> <> 0 <> 0 Th riati with rpct to th olatility o noi in th tination country ar: ρ ( m, ) ( ) ( m, ) ( ) [ ρ( m, ) ρ( m, )] ( ) 0 ρ <> <> 0 <> 0 Th riati with rpct to th olatility o noi in th hicl country ar: ρ ( m, ) ( ) ( m, ) ( ) [ ρ( m, ) ρ( m, )] ( ) 0 ρ > < 0 > 0 36

39 Appnix Tabl Currncy o Inoic in Intrnational Tra Tranaction: Data Sourc an Not Country Data Aailability Typ o Data Diaggrgation Aailabl Data Sourc an Not. Unit Stat 00,003 Bilatral, by traing partnr, by inutry. Both xport an import inoicing. Conintial. Ma aailabl by pcial rqut. BEA th Intrnational Pric Program collct ata on currncy olly to conrt pric into U.S. Dollar or th purpo o proucing pric inx. Th U.S. Cutom Sric collct th ata on th alu o import an xport, but o not p any ata on th currncy in which tra i conuct. Th ata collct i a ampl o orall tra rathr than ry tranaction. Unit Kingom Franc, Grmany, Italy, Canaa, USA, Japan. Worl, Eurozon, EU4, OECD, Oil Exporting Countri --- By $, Euro, Poun, Local Partnr Currncy, Othr. Variou pciic SITC (R3) co an commoiti. Both xport an import inoicing. Japan Braown by Worl, U.S. SouthEat Aia, an EU. Braown by $ Yn, Othr. Kora m0-00m04 Both xport an import inoicing. Data rport in prcnt o total tra inoic in ach currncy. Each yar i only rprnt by ata rom only on or two month: January (00), March ( ), an/or Sptmbr (99-997) Braown by $,yn, DM, poun, othr. Orall Tra Only Autralia 997Q-003Q Orall Tra Only $, yn, poun, Nw Zalan $, Autralian $, Variou Thi i publicly aailabl ata. Original ourc oun in Unit Kingom: HM Cutom an Exci Unit Kingom Import an Export Currncy o Inoicing, Fbruary 3, ata oun at Th ata ar not cor by th UK National Statitic quality itmar, o houl b iw a inicati rathr than a an xact maur. Spciically, th corag in thi ury i limit or all xport an or import rom th rt o th Europan Union, conquntly caution houl b xrci in intrprting th rult or a ingl yar. Thi i publicly aailabl ata. Original ourc i: Japan MOF Stuy Group or th Promotion o th Intrnationalization o th Yn Rport, Jun Japan Minitry o Intrnational Tra an Inutry, ownloa rom th Minitry o Financ wb it Thi i publicly aailabl ata. It can b oun in th Monthly Statitical Bulltin, 003 ol 57 no. 6, Ban o Kora, Tabl 5 Sourc: Kora National Statitic Oic, Downloa rom Data i or currncy inoicing an i proi in 4 catgori: Rcipt-Viibl Tra, Rcipt-Iniibl Tra, Paymnt-Viibl Tra, Paymnt-Iniibl Tra. Thi i publicly aailabl ata. Th ourc i th Autralian Burau o Statitic, Autralia Now "Intrnational Mrchani Tra, Autralia 003, atur articl 37

40 Bulgaria Blgium an Luxmbourg 998Q- 003Q Q-00Q4, 00 Grc Q-00Q4 Portugal Q-00Q4 Othr Aian Currnci, Othr. Both xport an import. Currncy inoicing ata. Orall Tra Only $,uro, DM, poun, ariou othr now unct Europan currnci Rport in prcnt har o import an xport or ach currncy. Euro, Othr or orall tra Extra-uro ara tra in Goo an Sric. $,uro, yn, poun, Othr. Extra uro ara xport an import o goo an ric Euro, othr Extra uro ara xport an import o goo an ric $, Euro, yn, poun,othr Export an Import Currnci, March /555aa9595bca560083c57!OpnDocumnt. Othr ata alo purcha rom ABS. Cutom claring ata rom th "Inormation Sric" Company, proc by th BNB an upplmnt with NSI ata. Prliminary ata a o 4-Mar S NSI BNB wb it lct Englih rion, thn clic tatitic -> orign tra -> Currncy Structur (all 4 il)) Conintial. Thi ata wa rci through a pcial rqut ia ECB. () Sparat ata or Blgium an Luxmbourg wr not aailabl in 000 an 00. All ata i or tra ttl in th rlant currnci. Euro ata or 00 an 00 inclu tra ttl in both Euro an in th Euro Zon lgacy currnci. Data wa rci in th orm o total alu ttl in Euro, US ollar, Yn, tc. rcor paratly or goo an ric (incluing tral). Conintial. Thi ata wa rci through a pcial rqut ia ECB. () Conintial. Thi ata wa rci through a pcial rqut ia ECB. () In th ca o xport an import o goo an ric th currncy braown rr to th currncy o ttlmnt, which may ir rom th actual currncy o inoicing. Spain Q-00Q4 Extra uro ara xport an import o goo an ric $, Euro, yn, poun,othr i) Th Spanih ata rr to th u o th uro a a ttlmnt currncy inta o inoicing currncy; ii) Data on ric xclu tral. Italy Extra uro ara xport an import o goo an Franc ,00qtr 000Q-0Q ric. Euro, othr Orall Tra $,yn, poun, Franc, Autrialian $, DM, Othr now unct Europan Currnci Total Euro, US$, Othr Extra-uro ara xport an import o goo an ric. Euro, US$, Othr Conintial. Thi ata wa rci through a pcial rqut ia ECB. () Th currncy braown o Spain tra in goo an ric with non-uro countri (call th xtra uro ara) ar ba on ttlmnt currncy inta o inoicing currncy. Thr i no way to a whn th ttlmnt currncy i alo th inoicing currncy. A th ata ha not bn publih yt, a propr chcing an claning proc ha not bn carri out, o th claning an th quality o Spanih ata cannot b guarant uicintly. Conintial. Thi ata wa rci through a pcial rqut ia ECB. () Conintial. Thi ata wa rci through a pcial rqut ia ECB. () Spcial rqut ia to Banqu Franc 38

41 Grmany Cypru,Etonia, Hungary, Latia, Polan, Soaia, Slonia 00Q-Q3 00Q-0Q Czch Rpublic irt 9 month Malayia/ Thailan Orall Tra $,uro, poun, othr Euro, US$, poun, Othr. Extra-uro ara xport an import o goo. Euro, US$, poun, yn, Othr 00 or 003 Braown proi or u o uro, ollar, poun, yn, rubl, an othr currnci, incluing tho o th accion countri. Conintial. Thi ata wa rci through a pcial rqut ia ECB. () In gnral, th ata ar ri rom a ury conuct twic a yar. Thi ury wa implmnt in 989 to cor orall tra xport or DM an om othr Europan inoicing currnci, USD an Yn. From 00 onwar, ata on currnci or tra import wr inclu; abo that, th ury wa xpan to implmnt th xtra uro ara tra braown. Sinc thn, th rpcti inoicing currnci ar bron own by EUR, USD, Poun Strling an othr. Conintial Europan Parliamnt briing ocumnt Th Latian cntral ban (Latija Bana) proi ata on thir wb it: Orall Tra. Euro, US$, poun, local currncy, Othr. Conintial. Thi ata wa rci through a pcial rqut ia ECB. () Czch Statitical Oic, xtract rom th wb it ( (A) Export an import combin. Data wa rci a th prcnt har o total inoicing or ach currncy. Sniong, Chirathp, Currncy Intrnationaliation in Slct ASEAN Countri, Unpublih Monograph, Intrnational Montary Fun, 997. Sourc: Sniong, Chirathp, Currncy Intrnationaliation in Slct ASEAN Countri, Unpublih Monograph, Intrnational Montary Fun, 997. Tabl rom "FINANCIAL AND MONETARY COOPERATION IN EAST ASIA: THE SINGAPORE PERSPECTIVE" Ngiam K Jin, Snior Fllow, Intitut o Southat Aian Stui, papr prnt at PECC Financ Forum Conrnc Iu an Propct or Rgional Coopration or Financial Stability an Dlopmnt, Honolulu Augut -3, 00 Not: Inutry pciic tail ar aailabl or th USA, Unit Kingom, Japan, an Autralia. () Data or 000 an 00 inclu tra ttl in uro an in lgacy currnci. Data rr to th u o th uro a a ttlmnt currncy, xcpt or Grmany. For Grmany, ata on tra in goo rlct th arag alu o ata collct in ury carri out in th irt an thir quartr o 00 on bhal o th Dutch Bunban. Data on ric or Grc, Portugal, an Spain xclu tral. 39

42 Appnix Tabl Altrnati Currnci in Tra Inoicing Currncy Shar in X Currncy Shar in M Latt Yar US $ Euro Yn US$ Euro Yn Unit Stat Aia Japan * * 3.5 Kora * * 9.8 Malayia * * 6.8 Thailan * * 8. Autralia Canaa Euro Union Blgium # 54.# 0.5# 33.5# 54.#.5# Franc #/. 55.8#/7.6 * 43.#/ #/70.0 * Grmany #/ #/ #/. 45.5#/ #/* Grc # 4.# 0.# 6.0# 30.7#.0# Luxmbourg # 49.#.7# 38.0# 37.4# 4.0# Portugal # 48.# 0.4# 34.5# 57.8# 0.9# Spain # 58.# 0.6# 39.5# 54.7# 0.8# U.K #/ #/5.0 * 6.0#/38.0.0#/0.0 * EU-Accion Bulgaria * * Cypru * * Czch * * Etonia * * Hungary * * Latia * * Polan * * Sloaia *. 60. * Slonia * * *- Data Not Aailabl or thi particular currncy. S Not on Tabl 4.3 or mor inormation about th ata ourc an at u. #Extra-uro ara tra. 40