VoxEU Column Monetary Policy

International currency competition redux

The US dollar has played a central role in the international monetary system, but it currently faces stiff competition from other currencies. This column argues that the benefits of international liquidity provision might be higher than previously thought when one accounts for general equilibrium effects. Quantitatively, the welfare cost of losing international status is not inconsequential for the issuing country. For the US, it amounts to between 0.4% and 1.1% of consumption each year. 

The US dollar as dominant currency

The US dollar plays a central role in the international monetary system. A 2006 Treasury report stated that nearly 60% of dollar banknotes are held abroad. Over the last half century, the dollar has also been the main currency used for trade invoicing, denominating international debt, and foreign exchange trades.

In addition to an international currency's role as a store of value and medium of exchange in cross-border goods transactions, it can also serve to invoice imports and exports, anchor the exchange rate, effectuate cross-border payments, denominate international assets and liabilities, and facilitate interbank transactions. Many of these uses are reinforcing, and the currencies used for pricing also tend to serve as means of payment. For instance, Goldberg (2011) finds that the US dollar maintains a dominant role in all key functions.  

Although these current arrangements are the joint outcomes of choices made by private citizens and regulations by official bodies, much of the international macroeconomic literature treats payment arrangements as given by restricting agents to only using a particular currency. While this assumption prevents the exchange rate from being indeterminate, as in Kareken and Wallace (1981), such an approach is unsatisfactory for understanding the conditions under which a currency can achieve international status, or how it might lose that status. Moreover, what are the implications of endogenous acceptance decisions for the choice of inflation in an open economy? And what are the welfare gains to having an international currency?

New research on the internationalisation of currencies

In Zhang (2014), I propose general equilibrium framework to be able to answer these questions. I develop a simple open-economy search model with multiple currencies to analyse three central issues in international monetary economics:

  • The conditions that allow for the emergence of an international medium of exchange;
  • The choice of inflation by monetary authorities when currency acceptability is endogenous; and
  • The welfare benefits of having an international currency for both the issuing country and the rest of the world. 

Search-theoretic models are particularly useful at addressing international currency use, since they explicitly formalise the essential role of money rather than assuming it exogenously. In this spirit, this column differs from much of the international macroeconomic literature by letting private citizens choose which currencies to accept as means of payment, and not fixing its role by assumption. By integrating recent advances in monetary search theory with international monetary economics, this column attempts to further our understanding of currency competition by providing micro-foundations for the internationalisation of currencies.

The model features two key ingredients that capture the fact that international monetary arrangements are the dual outcomes of choices made by private citizens and regulations by official bodies.

  • First, payment patterns are pinned down by letting private citizens choose which currencies to accept.

The basic idea is quite general, dating back to Jevons (1875) and Menger (1892), and has to do with the fact that an object that is widely recognisable, such as dollars in the US, is better at facilitating trade than alternatives such as foreign currency. For example, the fact that sellers in the US are not as familiar with pesos – they might be worried that they are counterfeits – makes them reluctant to accept pesos as payment unless some costly information is acquired,  as in Kim (1996) and Lester et al. (2012). The rise of the US dollar prior to World War I was partially due to the increasingly dubious nature of the quality of foreign bonds (see e.g. Eichengreen 2010). More generally, history is rife with instances where means of payment have been subject to deceitful intent. The clipping of gold and silver coins in medieval Europe and rampant production of fake banknotes in the 19th century US are notable examples, as documented in Mihm (2007) and recently formalised in Lester et al. (2012) and Li et al. (2012).

  • Second, government transaction policies are introduced in order to account for the fact that payment outcomes also reflect choices made by official bodies.

Historically, a currency will not become international unless there is a centralised institution that favours its use. This is often achieved in practice by announcing legal tender status or only accepting domestic money for tax payments. The basic idea is that by simply accepting a particular currency in its own trades, governments may induce private agents to do the same.

Set up of the model

In the two-country, two-currency model, agents interact first in international trade markets and then in a currency exchange market. The frictions in this environment are search frictions, private trading histories, and imperfect recognisability of assets. Each country issues one currency and is defined by two features: citizens in each country receive transfers of domestic currency, and meet each other more frequently than they meet foreigners. Trade entails exchanging local goods for a portfolio of currencies, with no restrictions on which monies can be used between private citizens. Since what sellers accept depends on what buyers hold, and vice versa, complementarities in the trading environment lead to multiple equilibria where zero, one, or two international monies can emerge. For instance, when information costs are sufficiently high, an equilibrium with two national currencies arises endogenously, a result that is difficult to achieve in previous dual-currency search models (previous dual-currency search models include contributions by Matsuyama et al. 1993 and Wright and Trejos 2001). Network externalities can lead to coordination failures, with no guarantee that the world will end up with a socially efficient monetary system.

By formalising the role of currency in payments, the model provides a channel through which monetary policy can affect prices, trade, and welfare. For instance, currency substitution occurs as an endogenous response to local inflation; as it becomes more costly to hold local money, agents start substituting with foreign currency such as dollars. This captures the phenomenon of dollarisation common in many Latin American and eastern European economies. The theory also emphasises an important influence on the choice of money as an international medium of exchange. Fundamentals, as well as expectations regarding other agents' behaviour, jointly determine this decision and thereby determine the circulation patterns that arise. Due to inertia, it is difficult to dislodge an incumbent currency from its international role, whose use is associated with low information costs. At the same time, a temporary disruption – such as a change in inflation – can permanently shift payment patterns. International currency use therefore reflects both fundamentals and history, consistent with what we observe in practice.

The model also explicitly formalises the strategic interaction among monetary authorities to obtain insights on the choice of inflation in interdependent economies. The dynamic policy game captures the trade-offs faced by policymakers and generates an inflation Laffer curve. While some inflation can benefit the issuing country through increased seigniorage from foreigners, too much inflation lowers the purchasing power of money and hence trade between countries. At the same time, the threat of losing international status puts an inflation discipline on the issuing country, similar to Li and Matsui (2009). When monetary authorities interact in a simple policy game, the issuing country must therefore trade off the temptation to inflate with the threat of losing international status to set an inflation rate that will generally deviate from the Friedman rule.

Concluding remarks

To illustrate these theoretical findings and quantify the welfare effects across countries, the model is calibrated to match international trade data. According to the theory, a country's welfare consists of seigniorage transfers across countries and the surplus due to liquidity provision to citizens net of any information costs incurred. Depending on inflation rates and the calibration strategy for the model's information costs, the welfare benefit to the US of having the dollar as the sole international currency ranges from 0.4% to 1% of GDP per year, of which approximately 0.1% to 0.2% of GDP is due to seigniorage. These estimates thus serve as upper and lower bounds, respectively, on the welfare gains from international currency use. This can also be compared with 0.4% of GDP from Portes and Rey (1998), who only include seigniorage gains and the savings due to reduced transaction costs. This suggests that alternative studies may underestimate the benefit of international liquidity provision, since previous models do not account for the general equilibrium effects an international currency has in expanding trade opportunities abroad.


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