Dollar Hegemony & World trade adjustment

Abstract

The international role of a currency is focused on the so-called vehicle currency theory. This theory is based on the observation that currencies with high volume share like the dollar are also characterized by particularly low transaction costs. It was, therefore, enough to emphasize the role of order processing costs for determining the bid-option spreads in the international markets. If there are conspicuous and visible fixed costs due to the presence of a dealer, the high volume transactions reduce the processing costs per transaction due to economies of scale. In other words, it implies that in a competitive dealership market the currencies with high volumes should have lower spreads. This inverse relationship between the volume and transaction costs has important implications for the emergence of a dominant international currency. This paper intends to address the issue of identifying the factors affecting the currency-selection in invoicing the international trade. It also empirically analyses the change in composition of the foreign exchange reserves across countries on the basis of COFER data and their relation to invoicing currency in foreign trade. The paper discusses the mechanisms of exchange-rate pass through into prices of goods as they enter a country. And in the end, it discusses about the future role of Euro in trade balance and in foreign assets reserves and the policy implications of the same.