Why the Dollar Maintains Its Dominant Role in Global Trade and Finance - U.S. AEI

by Jeong Jaehyung

Published 04 Feb.2026 09:50(KST)

Yonhap News

Why does the dollar hold a dominant position in international trade and finance?

Jesus Fernandez-Villaverde, a nonresident senior fellow at the American Enterprise Institute (AEI), argued in an article contributed to AEI on February 2 that the reason lies in its role as a mechanism for coordination. He contends that it is not the size of a country’s economy or its fundamentals that determine the dominant currency, but rather a "coordination equilibrium" and historical inertia.

Professor Fernandez-Villaverde stated, "Economic fundamentals set the stage for currency hegemony, but the outcome is decided by history, and once it is decided, it is hard to change," adding, "The dollar will maintain its dominant status until a shock large enough to break the coordination equilibrium occurs." He explained that the current tariff levels imposed by the Trump administration and the hegemonic rivalry with China do not yet amount to a shock of that magnitude.

Common explanations for dollar hegemony cite the Bretton Woods system, which designated the dollar as the key currency after World War II, the size of the U.S. economy, and the combination of deep and highly developed financial markets. The author noted, "That is correct, but it is not a sufficient explanation." The British economy had already become smaller than the U.S. economy by around 1900, yet the pound sterling maintained its status as the world’s dominant currency until the 1940s.

In a recent paper titled "International Currency Dominance," co-authored with Joe Abadi and Daniel Sanches, the author argued that the answer lies in "coordination."

For example, suppose an exporter in Thailand is deciding whether to receive payment in dollars. His choice depends on whether he will be able to use those dollars later, which in turn depends on whether his suppliers in places like Vietnam or Germany accept dollars. Their choices again depend on the choices of their own trading partners. Once the world has coordinated around the dollar, no one wants to deviate from that system. To deviate would mean holding a currency that fewer people are willing to accept.

According to the author, as a result, the international monetary system can converge into three types. First, in a "classical" system, everyone holds a diversified portfolio: for instance, holding dollars to buy U.S. goods and euros to buy European goods. Second, in a "dominant currency" system, a single currency is used everywhere, even in transactions unrelated to its home country. Third, in a "multipolar" system, multiple currencies coexist as international media of exchange.

From a theoretical standpoint, the classical system is unstable. Even a very small shock will tilt it toward either a dominant currency system or a multipolar system. However, once a dominant currency emerges, it is extremely difficult to dislodge. Because coordination is self-reinforcing, that equilibrium is stable. This is why currency hegemony can last for decades. It is not because economic fundamentals never change, but because the "coordination equilibrium" itself has inertia.

Governments can adopt a strategy of raising the real yield on their government bonds to internationalize their currencies. However, large economies enjoy a natural advantage. Foreign investors expect more opportunities to trade with a large economic area and therefore are willing to hold its currency even if it offers lower yields. Size begets dominance, and dominance begets persistence.

The author also analyzed several counter-scenarios. For example, could a trade war topple the dollar’s status? His findings indicate that even if the United States and the rest of the world imposed a permanent and reciprocal 30% tariff, the effect would not be sufficient. Trade with the United States would shrink, but the world would still settle transactions in dollars, simply because everyone else continues to do so. This is consistent with historical experience: the dollar and the pound sterling survived the era of heightened protectionism between World War I and World War II.

Could China’s rise then transform the system? Capital account liberalization, such as opening China’s capital markets, would not be enough on its own. However, if China were to aggressively expand its payment infrastructure and engage in interest rate competition, the renminbi could become a meaningful secondary international currency, even if not the dominant one. The author emphasizes that the coordination advantages enjoyed by an incumbent dominant currency are that powerful.

The author, Jesus Fernandez-Villaverde, is a nonresident senior fellow at the American Enterprise Institute (AEI). He also serves as the Howard Marks Presidential Professor of Economics at the University of Pennsylvania. His main research fields are macroeconomics, econometrics, and economic history. His recent research projects address various issues in monetary economics, the formulation and estimation of dynamic equilibrium models, and the historical impact of "fractured land" in Eurasia on state formation.