Vehicle Currency

An important feature of the international nancial system is that it overwhelmingly uses a major currency, such as the US dollar, as a vehicle in the exchange between other currencies. In this paper we construct an equilibrium model to study this feature. The model economy has a nite number of countries, and each country's goods are sold only for the country's own currency. Households obtain foreign currencies at trading posts. Each post involves one pair of currencies, and there is a xed cost of operating the post. We study two types of equilibria. One is the symmetric trading equilibrium, in which there is an active post for every pair of currencies and so there is no vehicle currency. The other is the vehicle currency equilibrium, in which all countries exchange for a particular currency rst and then use that currency to exchange for other currencies. We analyze how the use of a vehicle currency changes each country's consumption and welfare, relative to the symmetric equilibrium. We study the constraints on the in ation rate of the vehicle currency that must be satis ed in order for a currency to be a robust vehicle currency. Preliminary. Please do not quote. We thank Neil Wallace, Randy Wright, Cedric Tille, and participants at seminars at the University of Western Ontario, the Federal Reserve Bank of New York, the University of Washington, and the University of Oregon for comments. Both authors acknowledge nancial assistance from SSHRC and the Bank of Canada. Devereux also acknowledges nancial assistance from Target and the Royal Bank of Canada.