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The 'reserve currency' myth: the US dollar's current and future role in the world economy

International monetary system Monetary policy Central banks Foreign currency transactions

The US dollar exchange rate has become increasingly politicised. President Donald Trump has called for a weaker exchange rate, a move away from a long-standing and bipartisan rhetorical position favouring a “strong dollar”. At the same time, US Democratic presidential hopeful Elizabeth Warren has called for a managed exchange rate to boost employment and exports, while two members of Congress have sponsored a bill that would tax foreign capital inflows into the United States with a view to balancing its external accounts.

This increased politicisation is partly a symptom of a significant appreciation in the US dollar since President Trump assumed office. As this report will show, this appreciation is not inconsistent with a chaotic trade war and the Federal Reserve cutting interest rates. The US dollar exchange rate often appreciates on increased international political and macroeconomic risk.

Main points:

  • The US dollar remains the dominant currency for international trade and investment, foreign exchange market turnover and settlements, debt issuance and official foreign exchange reserves held by central banks.
  • The role of the US dollar reflects the unrivalled size, depth and liquidity of US dollar capital markets, backed by America’s high quality political and economic institutions.
  • Contrary to popular myth, the US dollar’s role owes very little to its status as a so-called "reserve currency." The US dollar share of the world’s foreign currency reserves is a symptom, not a cause, of its dominant role.
  • If foreign central banks were to hold less US dollar assets, it would make almost no difference to the US dollar exchange rate or interest rates. China’s holdings of US dollar reserves have no value as an instrument of international economic coercion.
  • The role of the US dollar does not depend on a "strong dollar" policy. So long as the US enjoys a floating exchange rate and an independent Federal Reserve continues to target domestic inflation, the United States does not have a meaningful or effective exchange rate policy.
  • The US dollar has seen significant cyclical swings in value against other currencies, consistent with the role of a floating exchange rate in moderating economic shocks.
  • The US dollar’s potential rivals are beset with problems. The Euro is part of a dysfunctional monetary union and its share in the international monetary system has declined over the last 15 years.
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