For a more extensive response to this question, click here.

Some people fear that the US dollar will stop being so popular, and that will cause an intolerable rise in inflation.  If the US is to experience intolerable inflation, it will likely be as a result of both domestic and international forces; therefore, the international role of the dollar does not tell the whole story.

Inflation is the general increase in prices of goods and services in an economy. The annual percentage change in the general price index (the consumer price index) measures the inflation rate of an economy. As each unit of currency buys less in the market, the economy is experiencing positive inflation because the general price of goods in that economy rises.

The growth of the money supply itself is seen as a tool to cause inflation, though it is not always effective at doing so. When an economy experiences a “liquidity trap”, the increase in the money supply does not yield anticipated inflation. Liquidity traps are believed to be the reason that major money injections sometimes do not result in predictable consumer price index changes (thus, do not result in proportional inflation).[1]

Right now the global demand for the dollar eats up much of the monetary base that would otherwise cause core price inflation in the US. There are no expectations that international institutions will dump their dollar holdings into the market as this action would ruin their own currency value (which is measured against the dollar), and no precedent for a country acting so poorly in their own, and global, interest. If it were to happen, the international community as a whole would intervene to protect the US dollar and thus their currencies before inflation hit. Therefore, academia is reluctant to assign a numerical quantity that determines when the dollar stops being the reserve currency.[2]

 

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Katherine Brown is a Research Associate at Castle Rock Investment Company with a Master’s in Global Finance, Trade and Economic Integration from the University of Denver.



[1] For a sampling of Krugman’s work concerning liquidity traps, see: Krugman (1998) “Japan’s Trap” at https://www.princeton.edu/~pkrugman/japans_trap.pdf; Krugman and Eggertson (2011) “Debt, Deleveraging and the Liquidity Trap: A Fisher-Minsky-Koo Approach” for the Federal Reserve of New York and Princeton University at http://www.frbsf.org/economic-research/files/PKGE_Feb14.pdf;

[2] Institutions funding the research considered include: Princeton, the Department of the Treasury, IMF, National Bureau of Economic Research, the Federal Reserve, and the London School of Economics.