Vehicle Currency - GMPI working paper no. 10 - FRB Dallas

While in principle, international payments could be carried out using any currency or set of currencies, in practice, the US dollar is predominant in international trade and financial flows. The dollar acts as a ‘vehicle currency’ in the sense that agents in non-dollar economies will generally engage in currency trade indirectly using the US dollar rather than using direct bilateral trade among their own currencies. Indirect trade is desirable when there are transactions costs of exchange. This paper constructs a dynamic general equilibrium model of a vehicle currency. We explore the nature of the efficiency gains arising from a vehicle currency, and show how this depends on the total number of currencies in existence, the size of the vehicle currency economy, and the monetary policy followed by the vehicle currency’s government. We find that there can be very large welfare gains to a vehicle currency in a system of many independent currencies. But these gains are asymmetry weighted towards the residents of the vehicle currency country. The survival of a vehicle currency places natural limits on the monetary policy of the vehicle country. JEL codes: F40, F30, E42 * Michael B. Devereux, Department of Economics, University of British Columbia, 997-1873 East Mall, Vancouver, B.C. Canada V6T 1Z1. [email protected]. Shouyong Shi, Department of Economics, University of Toronto, 150 St. George St., University of Toronto, Toronto, Ontario M5S 3G7, Canada. [email protected]. First version: March 2005. We thank Randy Wright, Neil Wallace, Cedric, Tille, Nancy Stokey, Bob Lucas and V.V. Chari for comments and discussions. We have also received valuable comments from the participants of seminars and conferences at the University of Western Ontario, the Federal Reserve Bank of New York, the University of Washington, the University of Oregon, the National Bureau of Economic Research (Cambridge, 2005), Minnesota Summer Workshop on Macro Theory (2005), Canada Macro Study Group (Vancouver, 2005), and the conference organized by University of Basel and the Swiss National Bank (Monte Verita, 2007). Both authors acknowledge financial assistance from SSHRC and the Bank of Canada Fellowship. Devereux also acknowledges financial assistance from Target and the Royal Bank of Canada. The views in this paper are those of the authors and do not necessarily reflect the views of the Bank of Canada, the Federal Reserve Bank of Dallas or the Federal Reserve System.