Sunday, February 06, 2005

The US has no balance of payments constraint

Robert Mundell explains how, under a dollar standard, the dominant currency country does not have to be bound by a balance of payments constraint because other countries will accumulate dollar reserves. This is the point that Ronald Mckinnon makes here. It is also what Charles De Gaulle referred to as the "exorbitant privilege" of the US.
Under a dollar standard the United States would, unlike other countries, have no balance of payments constraint. It would be in the same position as any country that ignored its foreign exchange rate, except for the fact that other countries would accumulate dollar balances as reserves. Whereas other countries would have to allocate their monetary policies to preserve balance of payments equilibrium, the US could direct its monetary instruments solely to the achievement of domestic stability. This is consistent with the fact that, in an n-country world, there are only n-1 exchange rates, and only n-1 countries need to pursue independent balance of payments policies, leaving monetary policy in one country free to pursue domestic objectives.
Of course, the exorbitant privliege is not infinite. If foreign countries lose confidence in the US dollar, the result will be an incredibly intense inflationary pressure in the US, much like what happened in the 1970's.


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