The importance of the U.S. dollar in the context of the international monetary system has been examined and studied extensively. In this post, we argue that the dollar is not only the dominant global currency but also a key variable affecting global economic conditions. We describe the mechanism through which the dollar acts as a procyclical force, generating what we dub the “Dollar’s Imperial Circle,” where swings in the dollar govern global #macro developments.

The Imperial Circle
Behind our analysis lies a multi-polar characterization of the global economy, comprised of the United States, advanced economy countries, and emerging market economies. In our multi-country DSGE model, as in the Dominant Currency Paradigm (DCP), we assume that firms in the emerging market bloc set their export prices in dollars while firms in advanced economy countries set export prices in their own currency. A stronger dollar therefore creates a competitive disadvantage for emerging market economies. We also assume that there are financing constraints so that firms need to borrow in dollars to finance purchases of imported intermediate inputs. As we show in our model simulations, presented in a recent staff report, these two forces make dollar appreciation particularly detrimental for the #manufacturing sector in emerging market economies.

The chart below visualizes the Dollar’s Imperial Circle. A tightening of U.S. monetary policy sets the circle in motion, generating an appreciation of the dollar. Given the structural features of the global #economy, tighter policy and an appreciation of the dollar lead to a contraction in manufacturing activity globally, led by a relatively larger decline in emerging market economies. The resulting contraction in global (ex-U.S.) manufacturing will spill back to the U.S. manufacturing sector due to the reduction in foreign final demand for U.S. goods. These same forces will also lead to a drop in commodity prices and world trade. In the final turn of our mechanism, given that the U.S. economy is relatively less exposed to global developments, the contraction of global manufacturing and global #trade is associated with a further strengthening of the #dollar, reinforcing the circle.

Background Structure.
Behind the Dollar’s Imperial Circle are two key asymmetries in the structure of the international monetary system and the U.S. economy. The first asymmetry arises from the fact that global use of the dollar in the international monetary system greatly exceeds the relative size of the U.S. economy. The following chart captures this fundamental asymmetry.

More precisely, research by Goldberg and Tille (2008) documents how the dollar is the dominant invoicing currency in international trade, which, consistent with our mechanism, acts to amplify the impact of dollar movements on global manufacturing. Besides its dominant role in trade invoicing, the U.S. dollar is also the dominant currency in international banking. About 60 percent of international and foreign currency liabilities and claims are denominated in U.S. dollars (see Bertaut et al. (2021)).

In addition, as discussed by Bruno and Shin (2021), a strong dollar tends to reduce the availability of the dollar financing needed to support supply chain linkages. As a result, movements in the dollar affect global activity through this financial channel. The chart below captures the link between the broad dollar index and global supply chain imbalances, a measure that builds upon the New York Fed’s Global Supply Chain Pressure Index (GSCPI).

The second asymmetry occurs as the U.S. economy is less exposed to movements in global trade relative to its trading partners. The chart below shows that over the past fifty years, trade has played an increased role for many countries—most notably in the euro area and China, where the size of exports as a share of GDP has more than doubled. In the United States, meanwhile, the importance of trade has remained relatively lower and stationary over the same period.

To summarize, we emphasize that these asymmetries present a dichotomy: the hegemonic role of the dollar in international trade and finance has expanded, while the exposure of the U.S. economy to the global economy has been relatively stagnant. This dichotomy creates the conditions for the dollar to act as a self-fulfilling procyclical force.

The Circle in Motion.
Examples of what can start the process include a hawkish shift in the Federal Reserve’s monetary policy stance (relative to that of other central banks) or a negative shock that hits the rest of the world harder (such as the 2022 energy shock, with the U.S. being energy self-sufficient).

Once the dollar begins to strengthen, the subsequent dynamics imply a decline in global manufacturing due to dollar invoicing and the credit-intensive global value chain. Manufacturing activity, where credit-intensive global value chains are more pervasive, will tend to suffer more.
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