Working Paper: NBER ID: w30984
Authors: Antonio Coppola; Arvind Krishnamurthy; Chenzi Xu
Abstract: The international monetary system of the last four centuries has experienced the rise, persistence, and fall of specific currencies as the dominant unit of denomination in global debt contracts. We argue that a liquidity-based theory is necessary to explain this pattern. Firms issue debt that can be extinguished by trading their revenues for financial assets of the same denomination. When asset markets differ in their liquidity, as modeled via endogenous search frictions, firms optimally choose to denominate debt in the unit of the asset that is most liquid. Equilibria with a single dominant currency emerge from a positive feedback cycle whereby issuing in the more liquid denomination endogenously raises the benefits of that denomination. This feedback mechanism has historically been seeded by governments committed to the largest pool of liquid assets in the same denomination. Once a dominant currency emerges, the government hosting the currency endogenously invests more in the liquidity of its financial markets, leading to further entrenchment of that equilibrium. Our theory explains the historical experiences of the Dutch florin, the British pound sterling, the US dollar, and the transitions between them. We rationalize the current dollar-dominant international financial architecture and provide predictions about the potential rise of the Chinese renminbi.
Keywords: liquidity; debt denomination; currency dominance
JEL Codes: E40; F33; G15; N20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| market liquidity (G10) | debt denomination choice (H63) |
| liquidity of the dollar (E41) | issuance of dollar debt (F34) |
| increased dollar issuance (F31) | greater liquidity (E41) |
| greater liquidity (E41) | incentivizes more dollar-denominated debt (F34) |
| US government's backing of treasury bills (H63) | superior liquidity environment (G19) |
| denomination in dominant currency (E42) | improves market thickness (G10) |
| liquidity dynamics (E41) | currency dominance (F31) |