The International Use of Currencies: The U.S. Dollar and the Euro

• Author: George S. Tavlas
• Position: Deputy Division Chief in the IMF's Treasurer's Department, is on external assignment as a Special Advisor to the Governor of the Bank of Greece and serves as the Bank's Alternate Member of the Monetary Committee of the European Union

Why does the international monetary system seem to need only one or, at most, a few national currencies to carry out international transactions? This article offers an explanation, discusses recent trends in the international use of the dollar, and assesses the possible impact of the euro in world financial markets.

FOR THE PAST half century, the U.S. dollar has served as the world's preeminent international currency, thwarting challenges from several other currencies in the process. In the early post-World War II period, the pound sterling provided some competition to the dollar, while in the 1980s the increased use of the deutsche mark and the Japanese yen led to speculation that the international monetary system was becoming a tripolar currency regime. By the early 1990s, however, the international use of the deutsche mark and yen stabilized at modest levels and expectations of a tripolar regime subsided. During the past few years, there has been increasing speculation that the international monetary system may become bipolar, with the dollar sharing the spotlight with a currency that has yet to come into existence-the euro.

International uses of a currency

Elementary monetary economics teaches that within a single economy, money fulfills three basic functions-it serves as medium of exchange, a unit of account, and a store of value. An international currency used among economic agents-that is, persons engaging in financial transactions-in multiple economies serves the same functions. As a medium of exchange, it is used by private agents both in direct exchange of currencies and as a vehicle currency in carrying out indirect exchanges between two other currencies in foreign trade and international capital transactions. It is also used by official agents as a vehicle for exchange market intervention and for balance of payments financing. As a unit of account, it is used to invoice merchandise trade, to denominate financial transactions, and-by official agents-to define exchange rate parities. As a store of value, it is used by private agents when they are choosing financial assets, such as bonds held by nonresidents. Similarly, official agents may hold both an international currency and financial assets denominated in it as reserve assets.

There is, however, one fundamental difference between the use of money in a single economy and the use of an international currency in a multieconomy setting. In the former context, governments typically declare (by fiat) the currency that is used as legal tender within their jurisdictions. For example, when receiving tax receipts, the Swiss government demands to be paid in Swiss francs and not in, say, Mexican pesos. In the international setting, however, the choice of currencies responds predominantly to market forces, whose consequences are ratified more than guided by international agreements. While the process determining the use of international currencies responds to market forces, there may be some inertia owing to the costs of changing currencies, as is explained later in this article.

Because the choice of international currencies is mainly a market-driven process, money's functions as a medium of exchange and a unit of account tend to predominate over its function as a store of value and to lead to the use of a single international currency or, at most, several international currencies. To explain this phenomenon, consider that modern portfolio theory suggests that-in order to diversify their risks-investors will typically choose to hold a wide range of international currencies as assets, with the particular quantities of each currency depending upon their respective risk and return characteristics. Consequently, if the choice underlying the international use of currencies depended exclusively on asset motives, many currencies...