9.3 Global Reserve Currencies and the Dollar's Role

The U.S. dollar's dominance as the global reserve currency stems from America's economic might and financial market depth. It serves as a medium of exchange, unit of account, and store of value in international transactions, shaping global trade and finance.

While the dollar's status brings benefits like lower borrowing costs for the U.S., it also poses challenges. Other currencies like the euro and renminbi are emerging as potential alternatives, raising questions about the future of the international monetary system.

Reserve Currencies and their Functions

Definition and Characteristics

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• A reserve currency is a foreign currency held in significant quantities by central banks and other major financial institutions as part of their foreign exchange reserves
• The status of a currency as a reserve currency depends on factors such as
  • Size and openness of the issuing country's economy
  • Depth and liquidity of its financial markets
  • Stability of its political and legal systems
  • Confidence of international investors in its long-term value

Roles in the Global Monetary System

• Reserve currencies serve three main functions in the global monetary system
  • Medium of exchange for international transactions
  • Unit of account for denominating international contracts and financial instruments
  • Store of value for central banks and investors
• The use of a reserve currency reduces transaction costs and exchange rate risks in international trade and finance allows countries to settle their balances in a widely accepted and stable currency
• The demand for reserve currencies affects
  • Their exchange rates
  • Balance of payments of the issuing countries
  • Global allocation of capital
  • Transmission of monetary policy shocks

The U.S. Dollar as Reserve Currency

Historical Emergence and Dominance

• The U.S. dollar emerged as the dominant global reserve currency after World War II
  • United States accounted for a large share of world output and trade
  • Dollar was backed by gold under the Bretton Woods system
• The dollar's role as a reserve currency was reinforced by
  • Size, depth, and liquidity of U.S. financial markets
  • Openness of the U.S. economy to trade and investment
  • Political and military power of the United States
• The dollar's share of global foreign exchange reserves has remained around 60-70% since the end of Bretton Woods in the 1970s despite the rise of other major economies and the growth of international financial markets

Contemporary Usage and Influence

• The dollar is used as the invoicing currency for a large share of international trade, especially in commodities such as oil
• The dollar serves as the funding currency for a significant portion of cross-border lending and investment
• The dollar's dominance has allowed the United States to benefit from
  • Seigniorage (revenue from the use of dollars abroad)
  • Lower borrowing costs
  • Ability to finance large current account deficits
• However, it has also exposed the U.S. economy to the effects of global financial cycles and currency fluctuations

Benefits and Costs of Reserve Currency Status

Advantages for the Issuing Country

• Seigniorage revenue from the use of the currency abroad
• Lower borrowing costs due to the high demand for assets denominated in the reserve currency
• Ability to finance large current account deficits without facing a balance of payments crisis
• Enhanced international influence and prestige allows the issuing country's government and firms to conduct transactions and settle disputes in their own currency

Drawbacks and Challenges

• Need to maintain a large and open financial system
• Exposure to global financial shocks and capital flow volatility
• Potential for overvaluation of the currency and loss of competitiveness
• Challenges for the conduct of monetary policy need to consider the effects on the global economy and feedback loops between the exchange rate and domestic economic conditions

Implications for the Global Economy

• Benefits include
  • Lower transaction costs
  • Reduced exchange rate risks
  • Stable anchor for international prices and contracts
• Costs include
  • Vulnerability to economic and policy shocks from the issuing country (United States)
  • Potential for global imbalances and financial instability

Challenges to Dollar Supremacy vs Alternative Currencies

Potential Challengers

• The rise of other major economies (European Union, China) has challenged the dollar's dominance
• Diversification of central bank reserves away from dollar-denominated assets
• The euro, launched in 1999, has emerged as the second-largest reserve currency accounting for around 20-25% of global foreign exchange reserves
  • Constrained by fragmentation of European financial markets and political and economic challenges facing the eurozone
• The Chinese renminbi has been promoted by the Chinese government as a potential alternative to the dollar through measures such as
  • Inclusion in the IMF's Special Drawing Rights basket
  • Establishment of offshore renminbi markets and bilateral swap agreements
  • Limited use as a reserve currency due to China's capital controls and lack of convertibility
• Other potential challengers include the Japanese yen, British pound, and Swiss franc constrained by the size and openness of their economies and depth and liquidity of their financial markets

Prospects for a Multipolar Reserve Currency System

• A multipolar reserve currency system would involve several currencies sharing the functions of a global reserve currency
• Prospects depend on factors such as
  • Convergence of economic and financial conditions across major economies
  • Coordination of monetary and exchange rate policies
  • Development of deep and liquid financial markets in alternative reserve currencies
• Transition to a new global reserve currency or multipolar system could be disruptive to the global economy would involve significant changes in
  • Pattern of international trade and investment flows
  • Pricing of financial assets
  • Conduct of monetary and fiscal policies