Key currency status: An exorbitant privilege and an extraordinary risk

Abstract

What are the costs and benefits of the dollar's status as the key currency in the international monetary system? Here, we present a calibrated two country model in which all exports are invoiced in the key currency, and government bonds denominated in the key currency are held internationally to facilitate trade, and as official reserve assets. We show that the “exorbitant privilege” accruing to the key currency country comes from three sources: (1) a bond seigniorage that we estimate to be worth about a half a percent of consumption per period to the United States, (2) asymmetric responses to exogenous shocks that are worth an additional quarter of a percent of consumption per period, and (3) a macroeconomic hegemony in monetary and fiscal policy, reflecting the fact that the key currency's policy instruments are more potent. But, there is also an exorbitant risk to being the key currency country. We show that the costs of a potential dumping of key currency bonds are also substantial. Moreover, there appear to be no obvious monetary or fiscal policy responses that would lower the costs significantly.