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This paper derives an optimal monetary policy in a world with a dollar standard, defined as an environment in which all traded goods prices are set in US dollars, so that exchange rate pass-through into the US price level is zero. We show that the US is essentially indifferent to exchange rate volatility, while the rest of the world places a high weight on exchange rate volatility. In a Nash equilibrium of the monetary policy game, US preferences dominate; the equilibrium is identical to one where the US alone chooses world monetary policy. Despite this, we find surprisingly that the US loses from the dollar's role as an international currency, since the absence of exchange rate pass-through leads to inefficient expenditure allocations within the US. Finally, we derive the conditions for a dollar standard to exist.

If the dollar were ever displaced by the euro, [the US]… would lose the enormous freedom it now enjoys in running macro-economic policy. Ambrose Evans Pritchard, Daily Telegraph, October 10, 2003. The US dollar occupies a unique role in the world economy. The dollar resembles an international currency, in the sense that it acts as a means of exchange in international goods and asset trade, a store of value in international portfolios and official foreign exchange reserves, and a unit of account in international commodity pricing.1 This predominance of the US dollar has been described by McKinnon, 2001 and McKinnon, 2002 as a world dollar standard. How does the special role of the US dollar influence monetary policy making in the US and the rest of the world? The quotation above suggests that the US has an advantage in policy making due to the fact that the rest of world holds dollars, and sets prices in dollars. Indeed many commentators argue that there is an enormous welfare gain to the US from having its currency used so widely (e.g. Liu, 2002). This paper examines the determination of optimal monetary policy in an asymmetric world economy, where the currency of one country (e.g. the US dollar) plays a predominant role in trade.2 While the US dollar has multi-dimensional role as an international currency, we focus on one particular aspect of this role — the importance of the currency in international export good pricing. We define a reference currency as one in which the prices of all world exports are pre-set. Many authors have noted (e.g. Campa and Goldberg, 2005) that prices of imported goods sold in the US economy tend to be much less affected by exchange rate fluctuations than do imported good prices in non-US countries. 3 Tavlas (1997) finds that during 1992–1996 98% of US exports and 88.8% of US imports were invoiced in US dollars. In addition, Goldberg and Tille (2005), using a new panel data set on the invoicing of international trade, find that the US dollar is the currency used for most transactions involving the US, and moreover, represents a vehicle currency in many trade flows that do not involve the US. These findings suggest that prices of a large fraction of exports to the US are pre-set in US dollar terms (which we refer to as local currency pricing, or LCP), and do not react quickly to movements of the exchange rate. However, exports from the US are also likely to have prices pre-set in dollars (producer currency pricing, or PCP). Hence import prices in other countries should be more sensitive to exchange rate movements. How does this asymmetry in international export good pricing affect optimal monetary policy? We show that at one level the model quite closely accords with popular wisdom about the position of the US dollar in the world economy. In particular, the monetary authority of the reference currency country places a very low weight on exchange rate volatility in its monetary policy loss function. By contrast, the monetary authorities of rest of the world will be much more concerned with exchange rate volatility. This seems to well approximate the observed indifference of the US to the exchange rate in monetary policy making. In addition, the reference currency country follows a more stable monetary policy than the rest of the world. More importantly, we find that the monetary policy game between the reference currency country and the rest of the world has a key sense in which the reference country is predominant. The Nash equilibrium of the asymmetric game is the same as that which would obtain were the reference currency monetary authority to choose both its own and the rest of the world's monetary rules to maximize its own welfare. In this sense, the asymmetry in international pricing gives the reference currency country a dominant role in international monetary policy determination. A natural question to ask then is how much the US gains from this predominant role of the dollar in export price setting.4 The surprising answer is that US residents are not better off, but rather are worse off. Expected utility for residents of the reference currency country, where pass-through from the exchange rate to the CPI is zero, is lower than that of the rest of the world, where there is full pass-through.5 The intuition why the dollar standard hurts the US is that when foreign export prices are set in US dollars, it prevents an efficient response of relative prices to underlying real shocks within the US. An efficient monetary policy will generally want to employ both expenditure level (affecting total aggregate demand) and expenditure switching (affecting the relative demand for one country's goods) effects. When import prices do not respond to the exchange rate, monetary policy cannot be used to generate expenditure switching effects. This has a welfare cost for the residents of the reference currency economy. Hence, in our model, the dollar standard is costly for the US economy. What explains the special role of the reference currency? There is a considerable literature on the determinants of an ‘international currency’. An early contribution by Krugman (1984) argues that there may be multiple equilibria due to network externalities. On the other hand McKinnon (2002) argues that the special role of the US dollar arose partly from the record of low inflation and stable monetary policy that the US economy followed in the post-WWII period. In a later section of the paper, we extend the model to allow exporting firms the choice of currency in which to set prices, and investigate the conditions under which there is an equilibrium where exporters in both countries will use the currency of a single country for price setting.6 Our results suggest that both the Krugman multiple equilibria explanation and the McKinnon policy-determined explanation are important elements in the selection of a reference currency. In the equilibrium of the monetary policy game, the reference currency country's monetary authority will follow a more stable (lower variance) monetary policy. As a result, this tends to lock in an equilibrium where exporters in both countries use this currency in which to set prices. But the reason that the reference currency monetary authority follows such a rule comes only from the fact that the currency is used as a reference in international trade pricing. 7 The paper is structured as follows. The following section develops the main model, which is covered briefly as it is only a slight extension of Devereux and Engel (2003). Section 3 derives the solution of the model for given monetary policy rules. Section 4 derives the optimal rules in Nash equilibrium of a game between monetary authorities. Section 5 extends the model to allow for the endogenous choice of currency in which to set prices. Section 6 concludes.

In the decades since floating exchange rates, the US dollar has remained a pre-eminent currency in international trade and finance — leading to a de facto dollar standard. This paper has extended the recent literature on monetary policy in sticky-price general equilibrium models to allow for a US dollar standard. We found that the equilibrium has many of the attributes of popular discussion of the predominance of US monetary policy in the world economy. In particular, a decentralized world of floating exchange rates acts so as to maximize the welfare of the US. But, in sharp contrast to popular discussion, we found that this situation brings no net benefits to the US, when compared to welfare of the rest of the world. US residents are worse off in the situation of having a dollar standard, compared to residents of the rest of the world.