Opportunities and Challenges of the U.S. Dollar as an Increasingly Global Currency: A Federal Reserve Perspective

Federal Reserve Bulletin, Sept, 2001 by Michael J. Lambert, Kristin D. Stanton

Over the past two decades, demand for U.S. currency, especially the proportion estimated to be held abroad, has increased markedly. As a result, U.S. bank notes are now the most widely recognized and used currency in the world. Businesses and households outside the United States have long held U.S. currency for savings, especially during times of crisis. Over time, businesses and households abroad are increasingly turning to dollars for transactions purposes.

The rapid growth of demand for U.S. currency has posed challenges for the Federal Reserve in meeting its congressionally mandated responsibilities for currency availability and distribution.(1) Those challenges lie in making certain that the Bureau of Engraving and Printing (BEP) prints adequate amounts of currency; that overseas distribution channels have sufficient capacity to distribute U.S. currency when and where it is needed; and that the integrity of U.S. currency is maintained by monitoring counterfeiting activity. In the process of meeting these challenges, the Federal Reserve has improved its methods of forecasting demand for U.S. currency, expanded currency distribution channels, and worked with the BEP and the U.S. Secret Service to protect against counterfeiting threats.

This article gives an overview of the evolution of the Federal Reserve's responsibilities for U.S. currency, particularly in relation to the increase in foreign demand over the past two decades. It also discusses work on counterfeit deterrence and concludes with a brief note on the future of currency and coin.

DEMAND FOR U.S. CURRENCY

The Federal Reserve measures demand for U.S. currency by the amount of currency in circulation.(2) From 1980 to 1998, currency in circulation increased an average of 8 percent per year--from $124.8 billion to $492.2 billion. In December 1999, in preparation for the century date change, currency in circulation increased 22.1 percent from its December 1998 level, to $601.2 billion. Uncertainty associated with the century date change increased the public's precautionary demand for cash, but as the event passed without incident, the public returned much of the currency it had amassed to depository institutions. Depository institutions, in turn, returned excess currency to the Reserve Banks. Thus, in the first quarter of 2000, the Reserve Banks received record levels of currency from depository institutions, and currency in circulation declined to $535.4 billion, a level more consistent with the historical trend (chart 1).(3)

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Domestic demand for currency is largely based on the use of currency for transactions and is influenced primarily by income levels, prices for goods and services, the availability of alternative payment methods, and the opportunity cost of holding currency in lieu of an interest-bearing asset. In the United States, demand (in terms of number of notes) for smaller denominations ($1s through $20s) exceeds demand for larger denominations ($50s and $100s). Consumers frequently use smaller-denomination notes for small transactions and alternative payment methods (for example, checks and credit cards) for large purchases.

In contrast, foreign demand is influenced primarily by the political and economic uncertainties associated with certain foreign currencies, which contrast with the U.S. dollar's high degree of stability. The dollar remains a stable currency backed by a highly productive economy with low inflation and by the assurance that it will not be demonetized, recalled, or devalued.(4) Because U.S. currency is held abroad primarily as savings, foreigners tend to hold high-denomination notes. According to one estimate, about three-fourths of $100 notes in circulation are held outside the United States.(5)

The foreign component of the amount of currency in circulation is estimated to have increased significantly beginning in the late 1980s and continued to grow through most of the 1990s (chart 2).(6) Because about 90 percent, on average, of the $100 notes ordered by the Federal Reserve Bank of New York appear to be paid out to foreign banking organizations to satisfy foreign demand, net payments (that is, shipments to depository institutions in excess of receipts from depository institutions) of $100 notes from the Federal Reserve Bank of New York form one basis for estimating international demand. Based on estimates of net payments, international demand for U.S. currency increased 219 percent from 1989 to 1990 during the Gulf War. As another example, from 1993 to 1994 international net payments increased 24 percent during the Mexican peso crisis (chart 3).(7)

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Other countries have induced their residents to substitute from the local currency to U.S. dollars, both as a store of value and as a medium for transactions. In the extreme, some governments have adopted the dollar as legal tender. Schuler and Stein categorize this process of dollarization as official, semiofficial, or unofficial. According to this classification, official dollarization, also known as full dollarization, occurs when a country adopts the U.S. dollar as both legal tender and as its predominant--or exclusive--currency.(8) Recent examples of officially dollarized countries include Ecuador (January 2000), El Salvador (January 2001), and Guatemala (May 2001); other countries, such as Panama (1904), have been dollarized for many years. Schuler and Stein define semiofficial dollarization as the use of U.S. dollars as legal tender, while both the local currency and U.S. currency are used in daily transactions. Examples of countries with semiofficial dollarization include the Bahamas, Cambodia, and Haiti. Finally, unofficial dollarization occurs when citizens of a country hold a portion of their financial wealth in U.S. dollars even if U.S. currency is not legal tender (or even legal to use at all). Some unofficially dollarized countries hold and use large amounts of dollars; others hold relatively small amounts.(9)