Abstract: While in principle, international payments could be carried out using any currency or set of currencies, in practice, the US dollar is predominant in international trade and financial flows. The dollar acts as a `vehicle currency' in the sense that agents in non-dollar economies will generally engage in currency trade indirectly using the US dollar rather than using direct bilateral trade among their own currencies. Indirect trade is desirable when there are transactions costs of exchange. This paper constructs a dynamic general equilibrium model of a vehicle currency. We explore the nature of the efficiency gains arising from a vehicle currency, and show how this depends on the total number of currencies in existence, the size of the vehicle currency economy, and the monetary policy followed by the vehicle currency's government. We find that there can be very large welfare gains to a vehicle currency in a system of many independent currencies. But these gains are asymmetrically weighted towards the residents of the vehicle currency country. The survival of a vehicle currency places natural limits on the monetary policy of the vehicle country.
Keywords: Vehicle currency; Transactions cost; Welfare gains
JEL Classification: F40; F30; E42