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Memory and the dollar

Will the dollar lose its dominant role in international transactions? This column argues that this will happen quite slowly, if at all. It presents new evidence that in developing economies, demand for dollars hinges much more on historical factors than on recent experience. The highest inflation rate recorded within a country over the past 30 years explains flows of cash dollars more compellingly than recent inflation rates.

Since the Second World War, the dollar has been the currency used most commonly in financial, trade, and cash transactions worldwide. Whether that will remain the case is the subject of an intensifying debate in global financial circles. Already, the euro is counted as the dollar’s dominant challenger, while China’s central bank governor, among others, has suggested establishing an alternative (some might say, rival) “super-sovereign reserve currency.”

Will the dollar inevitably decline and fall, and if so, how quickly? Will we witness a rapid coup (in currency time) occurring over the next ten years, as some commentators believe (see Chinn and Frankel, 2008)? Or will we see a much more gradual process owing to the built-in inertia of the dollar’s prominent role?

In recent research, we find considerable inertia in the demand for dollars. We report new cross-country evidence on the determinants of substitution to dollar banknotes and find that in developing economies substitution hinges more on historical than on recent experience. The highest inflation rate recorded over the past 30 years explains flows of dollar banknotes more compellingly than do recent inflation rates.

Demand for dollar banknotes

While there is considerable interest in the determinants of currency substitution – defined as the use of multiple currencies in a given country – there are few established empirical results. The primary reason is that the amount of hard cash in circulation is often unknown. Our work provides a window into this world of cash transactions by presenting the first systematic evidence on the country-level determinants of demand for physical cash dollars.

We show that a gravity model – a simple empirical model originating in the trade literature – explains international flows of currency as credibly as it explains international flows of goods and financial assets. (The gravity model has served as a standard workhorse for goods trade for decades and has recently been applied to characterise cross-border trade in financial assets. It states that the gross flow of trade between two countries should depend proportionally on their economic size and inversely on the distance between them.)

Distinguishing between the use of physical cash dollars as a medium of transaction (by the informal sector) or as a store of value (whereby a household’s savings may be the dollars hidden under its collective mattress), we find important roles for market size and transaction costs which are consistent with the traditional gravity framework. We also find roles for the nominal exchange rate, the size of the informal sector, the degree of competition with the euro, and the history of macroeconomic instability over the previous generation. We find no role for official trade flows.

Our data come from the Federal Reserve System's international cash distribution operations and include all wholesale shipments of dollars to and from the US between 1990 and 2007. The Fed is responsible for facilitating the provision of US dollar banknotes consistent with its responsibility to provide for an elastic supply of currency under the Federal Reserve Act. These shipments are made by using pallets, each transporting 640,000 hundred-dollar bills, or $64 million.

Figure 1. Monthly payments and receipts of US dollar banknotes

Our study assumes that higher flows of dollars from an individual country are associated with greater use of dollars in that country. This implies that the stock of dollar banknotes does not vary dramatically over the sample period in any one country, and that the flows we observe reflect a nearly constant rate of redemptions of currency in the country, that are likely replaced through other channels. Our assumption is consistent with the stylised fact that the overall stock of dollars abroad does not appear to have changed substantially over the sample period. This is illustrated by the close movements of total monthly payments and receipts of US dollar banknotes by the Fed in Figure 1.

New insight: Money on the mind

We find that the demand for dollars is, above all, about memory. The highest inflation rate recorded over the past 30 years has significant explanatory power in our model -- the demand for dollar banknotes goes up for a generation after an inflation shock -- while the recent inflation rate has none. Figure 2 shows the relationship across countries between the average level of receipts of dollars and the average maximum inflation over the past 30 years. Countries with the highest historical inflation experiences exhibit the highest usage of dollars.

Figure 2. Correlation of receipts and historical inflation

The usual suspects also matter. Movements in the bilateral exchange rate with the dollar and a recent history of exchange-rate volatility increase the demand for dollars, as does aggregate economic activity. Figure 3 illustrates the tight relationship between real GDP and usage of dollars across countries, consistent with the gravity model. Similarly, as expected by the model, increased transaction costs decrease the demand for dollars.

Figure 3. Correlation of receipts and real GDP

Also interesting is our finding that the usage of dollars rises with the size of the informal sector where presumably much unofficial trade occurs in dollars.

What about competition between the dollar and the euro? With the introduction of the euro in 2002, residents of countries on the monetary union’s periphery reportedly began to use euros instead of dollars. Given the large volume of euros outstanding and their much larger denomination notes than those for the dollar (€500 notes versus $100 notes), there is certainly scope for competition between the two currencies. We find that euros have supplanted the use of dollars, but only in the euro-area's periphery. Figure 4 shows that countries with higher levels of trade with the EU exhibit lower usage of dollars.

Figure 4. Correlation of receipts and trade with the EU


Our findings may help determine the demand for dollar banknotes as a secondary currency in developing economies going forward and so inform key policy decisions. For such economies, currency substitution can be a form of de facto dollarisation, which in turn places constraints on domestic monetary authorities.

  • Large amounts of foreign currency circulating in the domestic economy may make monetary policy interventions and exchange rate stabilisation programmes less effective.
  • They may also diminish the incentives to finance government deficits via domestic inflation, as a given amount of inflation will produce less seigniorage.

Assessing the country-level determinants of the use of dollar banknotes may also have important implications for the Federal Reserve’s balance sheet going forward, as the seigniorage it earns from currency in circulation is a major source of its revenue.

Disclaimer: The views expressed in this article are those of the authors and do not necessarily represent the view of the Federal Reserve Bank of New York or of the Federal Reserve System.


Chinn, Menzie and Jeff Frankel (2008), “Why the Euro Will Rival the Dollar”, International Finance, 11(1): 49-73.

Hellerstein, Rebecca and William Ryan (2009), “The Determinants of International Flows of US Currency”, FRBNY Staff Report No. 400.

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