International Monetary Economics Term Paper

  • Length: 10 pages
  • Subject: Economics
  • Type: Term Paper
  • Paper: #90325702

Excerpt from Term Paper :

Barry Eichengreen (2011) has speculated that the U.S. dollar may be on the decline as the world's vehicle currency. The dollar has performed this role since at least Bretton Woods, when the financial and political might of the United States allowed it to take the lead in the global financial system from Great Britain. However, that lead is being challenged today by two other currencies. One is the euro, which derives from the Eurozone, a basket of nations that has an economy around the same size as the United States. The other is from the Chinese yuan, a currency that is pegged to some degree to the U.S. dollar, but which is backed by the world's third-largest economy (behind the U.S. And Eurozone) and one that is growing rapidly. The creation of the euro immediately fuelled speculation that it would overtake the dollar as the world's vehicle currency, and the seemingly inevitable rise of China to become the world's largest economy has fueled speculation that one day the yuan could overtake the dollar as the world's most important vehicle currency.

Background

In order to analyze whether or not the dollar is in decline, or if either of these currencies is in a position to take over from the dollar as the world's vehicle currency, the role of the vehicle currency must be understood. All of the world's currencies are legal tender within their country (or region) of origin. However, a vehicle currency has use beyond those borders in trade. Some currencies have use in neighboring countries for trade -- for example the Singapore dollar can be used in Brunei and the Hong Kong dollar in Macau. Beyond such minor examples, the predominant vehicle currency is the U.S. dollar (Devereux & Shi, 2008). The dollar is used as a medium of international exchange in trade, for example between two nations where one does not have a dominant currency.

There are significant advantages to having a vehicle currency in international trade. One advantage is that both counterparties have foreign exchange rate risk only to the degree that their own currency is risky. Thus if a Canadian firm trades with an Argentine firm in U.S. dollars, each has foreign exchange rate risk relating only to domestic currency -- the Canadian firm has less foreign exchange rate risk and more hedging capability than does the Argentine firm by virtue of differences in their sovereign risk.

This hypothetical trade scenario illustrates other benefits of having a vehicle currency. Because the Canadian firm is not trading in Argentine pesos, it is not exposed to Argentine sovereign risk. For the Argentine firm, it will be cheaper to trade in the vehicle currency than to trade in the Canadian dollar, because the market for Canadian dollars in Argentina is going to be relatively low, implying wide spreads.

The vehicle currency therefore benefits world trade because it fosters liquidity. Eichengreen (2011) points out that despite his concerns, the U.S. dollar is still one of the currencies in 85% of foreign exchange transactions worldwide. This gives the dollar incredible liquidity, and the dollar is the most liquid foreign currency in virtually every country. The efficiency and security that this brings to trade is an essential component of the growing world economy.

Having established the usefulness of having a vehicle currency, it was a given that the dollar would be that vehicle. At Bretton Woods, it was established that all other currencies would be set at a rate of exchange relative to the dollar. This meant that the dollar would be the most liquid foreign currency across the capitalist world. When Bretton Woods was replaced with a free-floating system, many nations have pegged the value of their currencies to the dollar as a means of ensuring price stability domestically. While this strategy is generally not sustainable, it again highlighted the value of the dollar as a medium of exchange, even when the currency being exchanged was not actually a dollar. From the importance of the dollar, it also became the world's reserve currency, as noted by Eichengreen (2011).

Alternate Reserve Currencies

In the late 1970s, shortly after the free-floating currency system was implemented, it was speculated that the deutschmark could be a viable vehicle currency, especially in Europe, where it was viewed as benchmark currency even more than the pound. The mark became increasingly popular in this role through into the late 1980s/early 1990s (Lim, 2006). During this period, the use of the deutschmark as a vehicle currency in Europe became more prevalent, although it did not reach the level that the U.S. dollar held. At the time, of course, the ruble was also a vehicle currency use for exchange in the Eastern bloc.

Lim (2006) outlines why the deutschmark emerged as a contender for the role of vehicle currency. Not surprisingly, it relates to transaction costs. There are two main causes of transaction costs, relating to the bid-ask spread and the volatility of the currency. The bid-ask spread is ultimately going to be defined by liquidity. The more liquid a currency is, the lower its bid-ask spread. The dollar has long benefited from the fact that it has a high level of liquidity in all major and minor currency pairs. Part of this derives from Bretton Woods and part of this derives from the predominant role that the U.S. has in international trade. The rise of the deutschmark was facilitated by the predominant role that West Germany had in European trade. The use of a particular currency as a vehicle currency is subject to a feedback loop. The more a currency is used, the better its liquidity becomes, which in turn encourages more use of that currency as a vehicle currency. Underwritten by Germany's robust economy and role in European trade, the deutschmark was gaining momentum on the dollar.

The Treaty of Maastricht was signed, signifying that Europe was moving towards a common currency. This would eventually become the euro, and it would include both the deutschmark and the French franc as its major contributing currencies. With these and the rest of the Eurozone economies backing it, the euro quickly came into favor as a vehicle currency. The Eurozone's size was enticing, and the euro basically continued building on the momentum of the deutschmark.

The other cause of increased transaction costs is volatility. It was argued that the rise of the deutschmark coincided with an increase in relative volatility of the dollar. Consider the issue of hedging. The more volatile a currency is, the higher the costs of hedging will be (or the potential costs of not hedging, for that matter).

The case for the replacement of the dollar by the euro is reasonable. The Eurozone is the same size, economically, as the United States. It has generally been viewed as stable, although recent events call that assessment into question. With a strong central bank, the backing of major world economies in Germany and France, the euro enjoys good fundamentals. It has a high level of liquidity, and Europe's economic influence is arguably just as strong, and in many regions is stronger than the U.S.

Transaction costs associated with the euro have been low for most of its history. This has helped it to become a major currency. The U.S. dollar is increasingly influenced by the price of oil, owing the U.S. dependence on that particular commodity. This increases U.S. transaction costs. However, the price of oil is denominated in dollars, so there are lower transaction costs for buying oil in dollars compared to euros. This is one of the main arguments against the use of the euro as a vehicle currency. Until the world's major commodities are traded in euros instead of dollars, the dollar will remain the most liquid currency in the world. Goldberg and Tille (2005) made this point when they found that the predominance of the dollar as a vehicle currency is largely tied to its role as the currency of reference in major commodity goods and goods traded on organized exchanges.

The euro is also beset by significant problems at present, with many member nations having issues with their budget deficits and the cost of their sovereign debt. The threat of default is high for countries like Greece, Ireland and Spain, and as a result, the economic strength that underlies the euro is lower than it was during the euro's rise in the 2000s. These troubles were entirely predicted, because while the Eurozone has a central bank that can implement monetary policy, it does not have control over the fiscal policy of its members.

The current euro crisis is not necessary a long-term threat to the euro. While there are some calls to remove Greece from the Eurozone and other such measures, many observers believe that the current crisis will merely result in changes to the way that the Eurozone works, rather than an undoing of the common currency (Taylor, 2010). If the euro is able to emerge from the crisis, it will…

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"International Monetary Economics", 30 November 2011, Accessed.14 January. 2017,
http://www.paperdue.com/essay/international-monetary-economics-48031