Working Paper: CEPR ID: DP13391
Authors: Egemen Eren; Semyon Malamud
Abstract: Why is the dollar the dominant currency for debt contracts and what are its macroeconomic implications?We develop an international general equilibrium model where firms optimally choose the currency composition of their debt. We show that there always exists a dominant currency debt equilibrium, in which all firms borrow in a single dominant currency. It is the currency of the country that effectively pursues aggressive expansionary monetary policy in global downturns, lowering real debt burdens of firms. We show that the dollar empirically fits this description, despite its short term safe haven properties. We provide further modern and historical empirical support for our mechanism across time and currencies. We use our model to study how the optimal monetary policy differs if the Federal Reserve reacts to global versus domestic conditions.
Keywords: dollar; debt; dominant currency; exchange rates; inflation
JEL Codes: E44; E52; F33; F34; F41; F42; F44; G01; G15; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| aggressive monetary policy (E63) | lower real debt burdens (F34) |
| lower real debt burdens (F34) | firms' borrowing behavior (G32) |
| monetary policy of the Federal Reserve (E52) | dollar's status as the dominant currency (F31) |
| inflation in the dominant currency country (F31) | currency choice of firms (F31) |
| inflation risk premium (E31) | variation in dollar-denominated debt (F34) |
| firms' expectations about monetary policy effectiveness (E52) | currency choice for debt issuance (F34) |