A currency dominates other currencies when it is usedmore frequently as a unit of account,mediumof exchange, and store of value. Local currencies tend to dominate foreign currencies as means of exchange partly because the bulk of transactions is local and partly because governments discriminate in favor of the currency they issue. Legal tender laws and the fact that governments generally disburse funds and receive tax collections in the government-issued currency raise the cost of using other currencies as alternativemeans of payment in the domestic market. Currency substitution the replacement of domestic money with a (better) foreign money is a slow process even when it is permissible. Inflation must reach high rates before individuals switch out of a currency. For example, an inflation rate of 10 percent a month in the German hyperinflation of the 1920s led to a currency substitution of only 5 percent of the money stock.
At the international level, where legal restrictions matter much less and national currencies can freely compete, specific types of transactions tend to be denominated in international currencies to enhance market transparency, and international investments in different currencies are regularly held as a store of value. In the search for the preferred currency, transaction costs are one of the most relevant considerations. These costs decline as the transaction domain of a currency expands; call this the network value of money. Currencies that are not widely used have a low network value and are at a competitive disadvantage against widely used currencies. Once a currency reaches a dominant network value, it may gain frominertia: newer currencieswith similarly low transaction costs may not be able to quickly upstage the dominant currency (Rey 2001).
Historical evidence indicates that one currency tends to dominate others as an international medium of exchange and a store of value. The Roman silver denarius was the first world currency; the Byzantine solidus was the unchallenged coin from the 5th to the 7th centuries. But the international role of the solidus was challenged by the Islamic dinar, which eventually made the crossover; both lasted until the 12th century. In the 13th century, Italian coins came to prominence: the Genoese genoino, the Florentine fiorino, and the Venetian ducato. All three coins circulated side by side for quite some time (Cipolla 1956). In the 19th century, Britain was the leading industrial economy in the world, and the British pound became the leading international currency. Britain’s economic preeminence came to an end after World War I, but the key status of the pound lasted for more than four more decades (Eichengreen 2005). As late as 1965, 20 percent of official reserves were denominated in pounds, demonstrating how slowly a dominant currency can decline. The U.S. dollar emerged as the dominant international currency after World War II, but lost some ground toward the end of the 20th century, first with respect to the deutsche mark and the Japanese yen and later to the euro.
The U.S. Dollar and the Euro as Dominant Currencies
Several different functions are subsumed under the label of ‘‘international role of a currency’’: to invoice internationally traded goods and services, to employ as a vehicle currency (that is, as neither the exporter’s nor the importer’s currency) in foreign exchange markets, to denominate assets held by monetary authorities and the private sector, and to serve as a reference currency in defining fixed exchange rates (Cohen 1971; Kenen 1983).
The dollar remains the dominant invoice currency, even though the extent of its dominance has declined since the advent of the euro (Goldberg and Tille 2006). Specifically, according to available data, the U.S. dollar remains the dominant invoice currency outside of Europe, where the euro has surpassed the dollar. The dollar is the largest currency traded in the foreign exchange markets, with a market share of 45 percent of daily transactions; the euro follows with a share of 20 percent (BIS 2005). These shares remained stable between 2001 and 2004. The greatest advances made by the euro as an international currency are in international bond issues. According to data published by the Bank for International Settlements (2006, table 13 B), international bonds and notes denominated in euros exceeded those denominated in dollars. The ascendancy of the euro coincides with the increased degree of efficiency, liquidity, and integration of the euro financial markets (Portes and Rey 1998).
Following the depreciation of the dollar relative to the euro after 2002, the financial press focused on the prospect that central banks with large and increasing stock of international reserves especially those in Asia may want to substantially diversify their holdings out of dollars and into euros and, in the process, bring an end to the dominance of the dollar in official portfolios. Yet, according to data published by the International Monetary Fund (2005, table I.2), the dollar still retained the same reserve share in 2005 that prevailed at the end of the Bretton Woods system. The novel aspect in the data is that the euro has gained at the expense of currencies other than the dollar (the euro share in official reserves has gone from6.7 percent of the combined shares of the legacy currencies mark, franc, and guilder in 1973 to 25 percent in 2004). It is safe to say that the euro is becoming an established alternative to the dollar (Chinn and Frankel 2005).
With the United States and the euro area converging to similar economic and financial size, the race is now between two currencies that are backed by large and diversified regions and are integrated with the rest of the world both in trade and finance. Differences in policies will determine the outcome of the match for dominance. Hence the concern that the decline of the dollar may pick up speed if fiscal policy in Washington does not change.
Benefits of Currency Dominance
The United States benefits from the dollar as the preeminent international currency in a number of ways. First, it earns a ‘‘foreign’’ seigniorage on the dollar currency held abroad; data indicate that as of 2005, $352 billion, approximately 50 percent of outstanding U.S. dollar currency, is in the hands of nonresidents (Survey of Current Business 2006). Second, the special role of the dollar has permitted the United States to issue liquid and short-termforeign liabilities and invest in illiquid and long-term foreign assets; that is, the United States is the ‘‘banker of the world’’ (Despres et al. 1966). By borrowing cheaply relative to rates of return achieved on foreign assets, the United States has relaxed the external constraint typically faced by other countries. This is one reason that, as of 2007, theUnited States had accumulated a staggering net foreign debt without yet incurring a financial crisis.
Finally, U.S. importers are largely insulated from exchange rate movements because virtually all U.S. imports are invoiced in dollars, and only a small fraction of a change in the exchange rate is passed through import prices. This reduction in exchange rate risk means that a depreciation of the dollar does not have the traditional effect of significantly reducing the demand for imports and does not lead to a deterioration of the terms of trade. The policy consequence of this benefit to U.S. consumers is that a dollar depreciation is a weak tool to produce a switch fromimports to domestic goods and services and that a reduction of the trade deficit occursmostly through the export side.
In sum, the dollar remains the dominant international currency; the euro is a distant second most important international currency.Whether the euro will eventually overtake the dollar depends on the inertia accorded to the dominant currency and on the policies that will be pursued on both sides of the Atlantic.
See also Bretton Woods system; common currency; convertibility; currency competition; currency substitution and dollarization; dollar standard; euro; exchange rate pass-through; exorbitant privilege; gold standard, international; multiple currencies; optimum currency area (OCA) theory; reserve currency; seigniorage; vehicle currency