What Happened to the Good Old Days? the Role of Expenditure Switching in the Global Imbalance Adjustment

In this paper, we use a structural general-equilibrium approach to study whether the expenditureswitching role of exchange rates has changed in the G7 countries in the current episode of significant global imbalances. We develop a multi-sector two-country model for the United States and the G6 countries with the rest of the world captured by exogenous price and demand shocks, and estimate the model over two sub-samples, which covers the periods before and after the early 1990s. Our results indicate that both U.S. imports and exports have become much less responsive to exchange rate movements in recent years. This may suggest that the unwinding of the same amount of U.S. trade deficit would require a larger move in exchange rates now than in the 1970s and 1980s. Structural estimation reveals that the decline in the responsiveness of trade to exchange rates is due to changes both in the variances of structural shocks and in firms’ pricing behavior, as well as the increased size of distribution margins. JEL Classification: F3, F4 Bank Classification: Exchange Rates; Inflation and Prices; International Topics ∗I thank Ali Dib, Philipp Maier, Larry Schembri, and numerous seminar participants for helpful comments. Contact:[email protected].