FEDERAL RESERVE BANK OF ST.LOUIS an international currency and the major factors The Creation of the that determine whether a currency will be used outside its borders. It then examines the use of Euro and the Role currencies in international markets prior to the establishment of the euro and the changes brought of the Dollar in about by the creation of the euro.2 International Markets FUNCTIONS OF AN INTERNATIONAL CURRENCY Patricia S. Pollard Economists define money as anything that serves the following three functions: a unit of uring the nineteenth and the first half of account, a store of value, and a medium of exchange. the twentieth centuries, the British pound To operate as a unit of account, prices must be set was the preeminent international currency. D in terms of the money. To function as a store of It was used in both international trade and financial value, the purchasing power of money must be transactions and circulated throughout the British maintained over time.3 To function as a medium of empire. With the decline of British economic power exchange, the money must be used for purchasing in the 20th century, the U.S. dollar replaced the goods and services. For an international currency, pound as the leading international currency. For one used as money outside its country of issue, over 50 years the U.S. dollar has been the leading these functions are generally divided by sector of currency used in international trade and debt use—private and official, as listed in Table 1.4 contracts. Primary commodities are generally A currency serves as a unit of account for private priced in dollars on world exchanges. Central banks and governments hold the bulk of their international transactions if it is used as an invoice foreign exchange reserves in dollars. In addition, currency in international trade contracts. It serves in some countries dollars are accepted for making as a store of value if international financial assets transactions as readily as (if not more so than) the are denominated in this currency. It serves as a domestic currency. medium of exchange internationally if it is used as On January 1, 1999, a new currency—the euro— a vehicle currency through which two other curren- was created, culminating the progress toward econ- cies are traded, and as a substitute for a domestic omic and monetary union in Europe. The euro currency. replaced the currencies of 11 European countries: A currency serves as a unit of account for official Austria, Belgium, Finland, France, Germany, Ireland, international purposes if it is used as an exchange Italy, Luxembourg, the Netherlands, Portugal, and rate peg. It serves (i) as a store of value if govern- Spain.1 Two years later Greece became the 12th ments and/or central banks hold foreign exchange member of the euro area. 1 Although the Japanese yen and particularly the Although the national currencies will continue to exist until 2002, German mark have been used internationally in the they are merely subunits of the euro. past several decades, neither currency approached 2 Between the time that the Treaty on European Union established the process for the completion of economic and monetary union and the the international use of the dollar. With the creation creation of the euro, many economists studied the likely international of the euro, for the first time the dollar has a poten- role of the euro. Among these are Bekx (1998), Bénassy-Quéré, Mojon, tial rival for the status as the primary international and Schor (1998), Bergsten (1997), Hartmann (1996), Johnson (1994), Kenen (1993), Pollard (1998), and Portes and Ray (1998). Most of these currency. What changes in the international use of studies concluded that the euro would be a major international cur- the dollar have occurred in the first two years of the rency but that the process would be gradual. Bergsten and Portes and euro’s existence? What changes are likely over the Ray, however, expected a quick ascent for the euro. next decade? Moreover, what are the implications 3 This is the most difficult role for currency to achieve. Inflation reduces for the United States and the euro area as a result the purchasing power of money. As long as inflation is moderate, the ability of money to operate as a unit of account and medium of of these changes? To answer these questions, this exchange ensure its continued use. Hyperinflation causes money to article begins with an overview of the functions of lose its store of value function and is associated with an increase in the use of barter and substitute currencies. 4 Patricia S. Pollard is a research officer and economist at the Federal This sectoral division of the three functions of international money Reserve Bank of St. Louis. Heidi L. Beyer provided research assistance. was first adopted by Cohen (1971). © 2001, THE FEDERAL RESERVE BANK OF ST.LOUIS SEPTEMBER/OCTOBER 2001 17 R EVIEW Table 1 Functions of an International Currency Sector Function Private Official Unit of account Invoice Exchange rate peg Store of value Financial assets Reserves Medium of exchange Vehicle/substitution Intervention reserves in this currency and (ii) as a medium of Korean economy, U.S. exports comprise a much exchange if it is used for intervening in currency larger share of world exports. markets. Clearly the dominance of the U.S. economy The three functions of an international currency and the decline of the U.K. economy in the twentieth reinforce each other. For example, the use of a century were related to the rise of the dollar and currency for invoicing trade and holding financial the decline of the pound as international currencies. assets increases the likelihood that the currency Likewise, the growth of the German and Japanese will be used as a vehicle currency. In the official economies in the last several decades of the twen- sector, if a country pegs its exchange rate to another tieth century prompted the use of their currencies currency, it is likely to hold reserves in that currency in international markets. As a result, the overwhelm- and conduct its interventions in exchange markets ing dominance the dollar held in international in that currency. In addition, the use of an inter- markets in the 1950s and 1960s diminished. national currency by one sector reinforces its use Table 2 compares the relative size of the U.S., by the other sector. For example, using a currency euro-area, and Japanese economies. The U.S. econ- as an exchange rate peg facilitates the use of that omy is the largest in the world, accounting for about currency in debt contracts and foreign trade. 22 percent of world output. The establishment of economic and monetary union in Europe, linked DETERMINANTS OF AN through the euro, has created the world’s second INTERNATIONAL CURRENCY largest economy. The Japanese economy is less than half the size of the euro area.5 What determines the likelihood that a cur- The share of a country in international trade rency will be used in the international exchange as well as the size and openness of its financial of goods, services, and assets? Five key factors are markets are determinants of the demand for that as follows: country’s currency in world markets. The United States accounts for a lower share of world exports • Size of the economy than does the current euro area, as shown in Table • Importance in international trade 2. The size of U.S. financial markets as measured • Size, depth, liquidity, and openness of by the sum of bank assets, outstanding domestic domestic financial markets debt securities, and stock market capitalization, • Convertibility of the currency however, is much larger than in the euro area. Japan • Macroeconomic policies is a distant third in terms of its share of world The size of a country’s economy is important exports, but its financial markets are close in size because it determines the potential use of the to those in the euro area. currency in international markets. Economic size The convertibility of a country’s currency is is linked with the importance of a country in inter- another important determinant of its use in inter- national trade and the size of its financial markets. national markets. Restrictions on the ability to For example, exports account for a much greater share of the output of the Korean economy than 5 In 1994 the Chinese economy surpassed the size of the Japanese economy. Based on purchasing power parity valuations of GDP, China for the U.S. economy. Nevertheless, because the accounted for 11.2 percent of the world’s output in 1999. Nevertheless, U.S. economy is nearly 14 times larger than the Japan remains the world’s third major economic power. 18 SEPTEMBER/OCTOBER 2001 FEDERAL RESERVE BANK OF ST.LOUIS Table 2 Comparison of United States, Euro-Area, and Japanese Economies in 1999 United States Euro area Japan Share of world GDP (%) 21.9 15.8 7.6 Share of world exports (%) 15.3 19.4 9.3 Financial markets ($ billions) 40,543.8 24,133.4 20,888.5 Bank assets ($ billions) 7,555.3 12,731.3 6,662.5 Domestic debt securities outstanding ($ billions) 15,426.3 5,521.9 6,444.9 Stock market capitalization ($ billions) 17,562.2 5,880.2 7,781.4 NOTE: GDP is based on purchasing power parity equivalents. World exports excludes intra-euro-area trade. SOURCE: GDP: IMF, World Economic Outlook, October 2000. Exports: IMF, Direction of Trade Statistics Quarterly, September 2000. Bank assets: European Central Bank, Monthly Bulletin; Board of Governors of the Federal Reserve System, Flow of Funds Accounts; IMF, International Financial Statistics.