Dollar dominance holds up in modeled stress tests
An NBER working paper finds little change in dollar dominance across its tested scenarios, as separate research examines the conditions behind fiscal influence over monetary policy.
The US dollar’s dominance changes at most marginally across the scenarios tested by the authors of an NBER working paper, with no other currency emerging as a major player. The result supports persistence within those modeled scenarios; it supplies no prediction that dollar dominance will survive every possible shock.
The authors calibrate their model to nine reference currencies from the beginning of the Classical Gold Standard to the present. They examine shifts involving technology, development, institutions, democracy and conflicts, and regulation. Democracy and conflicts play an important role in the historical calibration, giving the dollar’s resilience in the tested scenarios a specific context: the authors allow for changes in which currency dominates.
Central-bank commitments face a different test in another NBER working paper. Its authors model a government that initially benefits from assigning an inflation target to a central bank, then faces a temptation to revoke that mandate to raise revenue through money creation. Whether the government keeps its commitment depends on shocks to fiscal fundamentals and the cost of abandoning the mandate.
In that model, the economy moves between periods when monetary policy follows its commitment and periods when the fiscal authority intervenes. The authors find sharply different relationships between inflation and debt relative to economic output across those regimes. They use the model to interpret fiscal and monetary history in Colombia, Chile and the United States.
How deficits influence inflation also depends on the assumptions economists build into their models. In a separate NBER working paper, the authors argue that fiscal dominance in a model built around a single representative household depends on spending and income reinforcing each other indefinitely. Within that framework, deficits drive output and inflation only through those infinitely lasting shifts.
The authors identify another route in models that distinguish among households: fiscal effects arising from finite planning horizons or constraints on available funds. Requiring the economy to return within a finite time to outcomes with freely adjusting prices eliminates the endless spending-and-income feedback, leaving that household-based mechanism. Their proposed refinement makes the analysis depend less on assumptions about beliefs stretching indefinitely into the future.