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Friday, March 11, 2011

Why is the dollar used internationally?

For years, U.S. Treasury notes have been a safe place for world governments to park their foreign currency holdings.

Since 1944, global markets have been pegged to the US Dollar as the reserve currency.

The world is on a de facto dollar standard, similar in some respects to the British pound sterling standard of the 19th and early 20th century. When did the US dollar become the international standard, and how likely is it to continue in that role?

Bretton Woods

In the aftermath of World War II, the relatively stable-valued US dollar was the only major currency in which international exchange could freely take place. The dollar's role was formalized under the Bretton Woods monetary agreement of 1944. Other nations set official exchange rates against the dollar, while the US agreed to exchange dollars for gold at a fixed price on demand by central banks.

This system functioned well for a brief period. However by about 1958 the initial worldwide dollar shortage had turned into an overabundance. With the too rapid growth of dollar credits around the world, gold backing of the dollar proved unsustainable. The Bretton Woods agreement collapsed in 1973, but it enthroned the dollar as the international medium of exchange. This unique role of the dollar continues to the present day.

How the Dollar Grew

The rapid growth of the industrialized economies after World War II created a growing demand for dollar balances around the world. The more of its own currency a central bank issued, the more dollars it wanted as underpinning for its currency.

During the Bretton Woods period, the US ran large current account surpluses. That would have drained dollars from abroad, but long-term capital outflows in the form of grants and direct investments by the US were greater than its current surpluses. The result was a build up of dollar assets by foreign firms and central banks. In effect, the US was lending long more than it was borrowing short, thereby satisfying the world’s growing demand for dollar liquidity, even while it remained a net creditor.

The Dollar Today

Today over half of all dollar notes in circulation are held outside the borders of the US. About half of US Treasury securities are owned by foreigners, mainly held as reserves by foreign central banks. The dollar is the main currency in international capital flows, as well as the currency of invoice for commodities and for many manufactured goods and services. All countries that trade directly with the US invoice both imports and exports in US dollars. Eurodollars often trade without any involvement by US participants.

Advantages for the U.S.

With the dollar as the world standard, the US is free to conduct its monetary policy independent of exchange rate fluctuations. In this respect, other countries operate at a disadvantage. They are reluctant to see their own currencies depreciate against the dollar because of the domestic inflationary threat that presents. They are also reluctant to allow a substantial appreciation of their currency against the dollar for fear of losing competitiveness in world markets. Consequently they sometimes subordinate their domestic monetary policies in order to stabilize their currencies against the dollar.

A Useful Analogy

The international dollar is analogous to the fiat money that a central bank issues within its own monetary domain. Central banks do so by purchasing assets from those who want to hold their currency as a store of value or for use in trade. There is little or no need for a central bank to concern itself with redeeming its own currency.

Likewise the US can issue dollar-denominated claims to the rest of the world which may never have to be redeemed so long as it maintains the domestic purchasing power of the dollar. While this gives the US a unique advantage in terms of borrowing in its own currency, the existence of a safe reserve asset is a great convenience to other countries. Only a serious loss of confidence in the dollar could depose it as the primary medium of international exchange, such as might be due to a prolonged major inflation in the US. Visit the source.

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