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International Medium of Exchange: Privilege and Duty

Ryan Chahrour and Rosen Valchev ()
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Rosen Valchev: Boston College, Postal: Dept. of Economics, Boston College, Chestnut Hill, MA 02467 USA

No 934, Boston College Working Papers in Economics from Boston College Department of Economics

Abstract: The United States enjoys an “exorbitant privilege” that allows it to borrow at especially low interest rates. Meanwhile, the dollarization of world trade appears to shield the U.S. from international disturbances. We provide a new theory that links dollarization and exorbitant privilege through the need for an international medium of exchange. We consider a two-country world where international trade happens in decentralized matching markets, and must be collateralized by assets — a.k.a. currencies — issued by one of the two countries. Traders have an incentive to coordinate their currency choices and a single dominant currency arises in equilibrium. With small heterogeneity in traders’ information, the model delivers a unique mapping from economic conditions to the dominant currency. Nevertheless, the model delivers a dynamic multiplicity: in steady-state either currency can serve as the international medium of exchange. The economy with the dominant currency enjoys lower interest rates and the ability to run current account deficits indefinitely. Currency regimes are stable, but sufficiently large shocks or policy changes can lead to transitions, with large welfare implications.

Keywords: Home Bias; Information Choice; Portfolio Choice; Dynamics (search for similar items in EconPapers)
JEL-codes: F3 G11 G15 D8 D83 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge and nep-mon
Date: 2017-10-06
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