Economic Report President

ances when such imbalances become unsustainable. The fact that borrowingmay occur in domestic or foreign currency has little to do withsuch sustainability.Disadvantages of having a key currency. Having an internationalcurrency confers at least two disadvantages on a country. These drawbacksexplain why Germany, Japan, and Switzerland have in earlierdecades been reluctant to have their currencies held and used widelyoutside their borders.The threat of large fluctuations in demand for the currency is one disadvantage.It might be that the more people around the world hold aninternational currency, the more demand for that currency will vary. Suchinstability of demand, however, is more likely to follow from the increasein capital mobility than from key currency status per se. In any case, centralbanks are particularly concerned that internationalization of theircurrencies will make it more difficult to control their money stocks. Thisproblem need not arise if they do not intervene in the foreign exchangemarket. But the central bank may view letting fluctuations in demand forthe currency be reflected in the exchange rate as just as undesirable asletting them be reflected in the money supply.The second disadvantage is an increase in average demand for thecurrency. This is the other side of seigniorage. In the 1960s and 1970sthe Japanese and German governments were particularly worriedthat, if domestic assets were made available to foreign residents, aninflow of capital might cause the currency to appreciate and render thecountry’s exporters uncompetitive on world markets. Some Europeanstoday express the same concern about the euro.What Factors Determine International Currency Status?Will the dollar maintain its global role in the foreseeable future? Theanswer depends on four major conditions that determine whether acurrency is used internationally.Patterns of output and trade. The currency of a country that has alarge share in world output, trade, and finance has a natural advantage.The U.S. economy is still larger than the euro-11 economies combined.If the United Kingdom and the other remaining EU members(Denmark, Greece, and Sweden) join EMU in the future, however, thetwo currency areas will then be very close in size.History. There is a strong inertial bias in favor of using whatever currencyhas been the vehicle currency in the past. Exporters, importers,borrowers, lenders, and currency traders are more likely to use a givencurrency in their transactions if everyone else is doing so. For this reason,the world’s choice of international currency is characterized bymultiple stable equilibria; that is, any of several currencies could fillthat role under certain conditions. The pound remained an importantinternational currency even after the United Kingdom lost its position303