By Ryan Chahrour and Rosen Valchev
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 safe 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.
Many in the United States do not realize their luck, as the exorbitant privilege is quite substantial. This paper finds this advantage amounts to about of 2% consumption, in large part thanks to the ability to keep a substantially lower net asset position. While this privilege is relatively stable, one can lose it if you rock the boat too much, though.