Dynamics of External Adjustment

Dollar currency paradigm means that dollar matters a lot in global trade. So suppose, India and Brazil are involved in a bilateral trade whereby India buys oil from Brazil while Brazil buys pharmaceutical drugs from India. Now, it's assumed that the prices are set in the currency of the exporting nation, that is, oil is priced in Brazilian real while drugs are priced in the rupee. What happens when the real-rupee exchange rate depreciates, that is, more rupees being required to buy unit real relative to before.

Conventional theories suggest that weaker rupee would make Indian drugs cheaper for Brazilians, thereby increasing its demand and thereby increasing Indian drug imports into Brazil or Indian exports of drugs. Note that the prices are assumed to be sticky which enables demand fluctuations to translate into volume fluctuations. A weaker rupee would make Brazilian oil expensive and reduce its imports in India or reduce Brazilian oil exports to India. In short, India's exports would increase while reducing imports, that is, trade balance improves. While for Brazil, exports would decrease and imports would increase the worsening trade balance.

According to dollar pricing, the prices of Indian drugs and Brazilian oil are set in dollars rather than their own producer or local currency. This makes trade less sensitive to the real-rupee exchange rate but making their relationship with the dollar more important. So, suppose rupee falls relative to dollars, that is, requiring more rupee to buy a dollar. This would make Brazilian oil priced in dollars expensive for Indians. However, Indian drugs priced in dollars would not be effected for Brazilians. Therefore, while Indian imports of oil would reduce, or Brazilian exports would reduce, Indian exports wouldn't alter. This would improve India's trade balance while worsening that of Brazil's. So the export volumes won't react much to the depreciation of selling the country's currency, India and the main effects come through lower imports in the short run. In the medium term, however, conventional economics hold as the depreciation would increase India's export volume sensitivity as well, that is, increasing its exports as well. 

Thus, while in the short term the Indian trade balance would be mainly influenced by imports (reduced), in the medium term, both imports (reduced) and exports (increased) would have an effect.

Dollar dominant paradigm is very interesting and recommended study for the students in international trade and macro. This shows how the modern economy differs from our conventional thought-process of its working. Click here to read the IMF blog.