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What is the Hegemony of the U.S. dollar?

What is the Hegemony of the U.S. dollar?

Nobel Prize Winning Economist & Stanford Professor Paul Romer on Hyperinflation & Protecting Science

The US Dollar has become the most popular currency all over the world in the past decades  after World War II. Many countries have used this global currency as their currency target, which  means their currencies have set a fixed exchange rate or pegged fixed exchange rate to the US  Dollar. Also, countries with the floating exchange rate are highly influenced by the fluctuation of  the US Dollar.

More importantly, the US Dollar works as the official currency in the global market,  and it plays an important role in international trade. As a result, many countries value the US Dollar  as a vital strategic foreign exchange reserve in order to deal with the predicament when facing  some extreme financial crisis. Hence, policies from the Fed and the US government could affect  the global economy to a large extent. Since the US Dollar has a prominent influence globally, it is  interesting to investigate how this system was established and developed, and it is meaningful to  prospect the future of the US Dollar based on the history and current global financial crisis. 

The origin of US Dollar Hegemony was inseparable from the Bretton Woods System, and World  War II provided an unprecedented opportunity for the US Dollar to become the global currency.  During World War II, European countries had to buy war gear from the United States. In exchange,  huge amounts of gold outflows from Europe to the United States. As a result, the United States obtained a tremendous amount of gold reserves in the central bank. “By the end of 1948, the US held 21.7 thousand tons – an astonishing 75% of all the gold held worldwide by central banks”  (US Gold Reserves vs. US Money).

After World War II, since Britain suffered greater losses,  the British Pound no longer worked as the global currency. In 1944, under the Bretton Woods  Agreement and System, the US Dollar replaced the British Pound as the new global currency. In the  agreement, “gold was the basis for the U.S. dollar and other currencies were pegged to the U.S.  dollar’s value” (Chen). However, this was not sufficient for the US Dollar to start up the hegemony. 

Since Europeans had no money to consume during that time, the United States used another step  to make the US Dollar get more power. In 1947, Marshall Plan “gave $13 billion in foreign aid to  European countries that had been devastated physically and economically by World War II”  (Kenton). This plan seemed to give European countries a hand to help them to resuscitate their  economy, but it was actually the establishment for the US Dollar’s future hegemony.

This change enabled the United States to influence the global economy. It was because the aid was in the form of the US Dollar, which means European countries were restricted to use the US Dollar to buy the  United States’ commodities. Because of these policies, the US Dollar obtained two prominent  advantages to become the global currency: global liquidity and huge profit for the United States.  The settlement of accounts between European countries and the United States in international trade  used the US Dollar, which made the US Dollar circulate globally. Besides, the United States earned  a lot of profits through international trade because the United States’ territory did not experience  the war, and the United States had excess commodities to export. 

However, the Bretton Woods System had not lasted too long, and it failed in 1971 because the United States printed huge amounts of US Dollars without coordinating with the gold reserve they had. When countries across the world wanted to exchange the US Dollar to gold, the United States’  government was not able to actualize the process. Consequently, the whole system failed, and the  US Dollar had to decouple from gold. In order to maintain the hegemony of the US Dollar, the US  Dollar started to convert from the gold-dollar to the petrodollar system.

“In 1979, the United States  and Saudi Arabia negotiated the United States-Saudi Arabian Joint Commission on Economic  Cooperation” (Amadeo). They agreed to use the US Dollar for oil contracts. As a result, most oil exporters became forced to peg their currency to the US Dollar. Since crude oil is the essential  commodity to all the countries, the close connection between oil prices and the US Dollar had an  important influence globally. 

The whole US Dollar system became established well after World War II, and the global economy  could not have developed without the US Dollar. The global economy developed quickly through  international trade. The United States obtained the largest consumer power since 1974, and it  formed a huge deficit with other export developing countries such as China. Through this strategy,  the US Dollar obtained its leading position in the global market.

More than that, it brought many  benefits to the United States. Export countries gained huge amounts of US Dollar as their foreign  reserve through international trade. Many export countries, as a result, view the US Dollar as their  currency target. For example, China utilized fixed exchange (“8.28 to the dollar for more than a  decade starting in 1994”) and “managed float” (“to a level of 6.83 to the dollar” from 2005 to 2008)  strategies in the past decades (Picardo).

For this kind of export country, they obtained tremendous dollars and they could not find high-quality assets to invest other than US treasury bonds. As a  result, most US Dollars flowed back to the United States. Since the treasury bonds rate is low, the United States was able to use the money they “borrowed” by selling treasury bonds to invest again  in many developing countries and made huge profits from it. This forms the perfect closed loop  under the US Dollar system. On one hand, this cycle set the US Dollar as the core of the global  economy. On the other hand, it prompted the United States’ economy, other countries’ economies,  and the global economy. 

However, other countries’ economic development was not sustainable when the Fed  manipulated the interest rate and printed money without control. Through the system, the change  in interest rate had huge ramifications on the global economy. During the interest rate cut period,  as the US Dollar flows into the global market, the price of assets in the global market increases  and the global economy develops dramatically.

However, during the interest rate increase period,  since the interest rate in the United States becomes higher, many US Dollars flow back into the  United States. Consequently, under the foreign exchange model, demand for US Dollar increases  and demand for domestic currency decreases, and the US Dollar in turn appreciates and other  domestic currencies depreciate. This brings huge fluctuations and disasters to many countries’  economies. From two huge financial crises, the Latin American debt crisis and the Asian financial  crisis, the change in US Dollar interest rate played an important role in those crises.

For example,  in 1994, many Asian countries pegged their domestic currency to the US Dollar. As the Fed  increased the interest rate, Asian countries were not able to use sufficient foreign reserves to  maintain the fixed exchange rate. It caused huge problems in the Asian financial market. “As a  result of the devaluation of Thailand’s baht, a large portion of East Asian currencies fell by as much  as 38 percent. International stocks also declined as much as 60 percent” (Chappelow).

The depreciation of Asian currencies had a huge influence on Asian countries’ bank systems.  Consequently, it brought on currency liquidity problems and short-debt defaults. The Asian  economy endured a huge loss and experienced recession during this Asian financial crisis. It can  be explained by the IS model. During the financial crisis, for Asian countries, the IS curve shifted  to the left because of the huge drop in consumption and investment, which decreased GDP to a  large extent. More importantly, during those huge financial crises, the US Dollar went strong. 

When the US Dollar appreciated and other currencies depreciated during a financial crisis like the  Asian financial crisis, the United States’ capitals were able to invest in superior assets in those  countries that just experienced a financial crisis by using fewer amounts of US Dollars than those  assets used to be. Thus, this is the reason why the US Dollar has been so powerful that it could  have incredible influence in the global economy. 

The whole US Dollar system, which includes the switch between the cut and increase period  of interest rate and how it has influenced the global economy, can be supported by historical data  from FRED and Yahoo Finance. Two key data, Effective Federal Funds Rate and US Dollar Index, 

Figure 1: The Effective Federal Fund Rate from 1970 to 2020 (FRED)

can reflect the historical events. In Figure 1, around 1980 and 1995, the interest rate increased dramatically compared to the previous interest cut period. Similarly, in Figure 2, from 1980 to  1985 and from 1995 to 2000, the US Dollar index hit the peak of the graph, which represented  that the US Dollar during those periods appreciated a lot compared to other currencies. From those  two periods, the reasons that caused the Latin American debt crisis and the Asian financial crisis  can be explained to a large extent. It illustrates how the US Dollar and interest rate have a huge impact on the global economy. 

Figure 2: US Dollar Index from 1970 to 2020 (Yahoo Finance)

For the future of the US Dollar, the prospect is that the US Dollar will still obtain the dominating power in the global market, but it will have less influence than it used to. It is because  there were some problems in the manipulation of the US Dollar system. In Figure 1, the effective  federal fund rate has kept a very low rate for about a decade after the 2008 financial crisis.

The reason why the Fed kept the interest rate at such a low rate is understandable. Referring to the ISLM model, the United States’ economy could be brought back to its original level by decreasing  interest rate, and in turn shifting LM downwards, increasing the GDP. However, the economy was  not promoted to a high level as expected, and during the last decade, the United States seems to  experience stagnation, where the economy growth rate, interest rate, and inflation rate all grow  slowly.

Moreover, it could potentially cause a bubble into the United States’ economy as well as the global  economy because the interest rate is so low that a large amount of US Dollars could be borrowed  and invested in the United States and global market. As a result, the virtual economy such as the  stock market could be decoupled from the real economy. The stock market could be more  overheated and overvalued than it should be. This projection can be tested and supported by the  current stock market.

Currently, in 2020, the bubble blows up and heavily affects the United States’  and global economy. The reason that my prospect of the future of the US Dollar is pessimistic is  that currently, the interest rate hits zero lower bound and the Fed no longer has the power to prompt  the economy back to normal. As Brian Cheung reported on Yahoo Finance about recent financial  movement: “In the wake of the coronavirus, the Fed had already slashed interest rates to zero,  announced over $1 trillion of liquidity support to money markets, and coordinated with central  banks around the world to address a U.S. dollar shortage” (Cheung). Nevertheless, this action has  a minor effect on the current market. Instead, it causes another huge problem, a high debt ratio,  which could be a potential bomb in the future economy and the US Dollar system. 

It is the common strategy for the United States to have premature consumption excessively by  using treasury bonds, and it is also the tool for the Fed to keep low inflation rate by manipulating  treasury bonds although money supply in the public is too high due to low-interest rate. The United States’ debt ratio keeps increasing from 2000 because of the huge trade deficit as mentioned before.  The excessive US Dollar printed by the United States is absorbed by increasing treasury bonds and  debt. In other words, inflation pressure is converted to a high debt ratio.

Although the interest rate  is low currently, which will not cause a debt crisis in the short run, it will still cause huge financial  problems in the future. In response to the potential inflation and collapse of the US Dollar due to  the large flow of US Dollar globally, many countries have less confidence in US Dollar and  treasury bonds than before. For example, China, the country that owns the largest percentage of  US treasury bonds, sold most US treasuries in nearly two-and-a-half years (Leong). Besides, many  countries have tried to buy gold to escape US dollars. 

“This global gold accumulation has continued unabated into 2019. Central banks around the world  are increasing their gold reserves more than any time in the past 50 years; China, Russia, Turkey,  Hungary, Kazakhstan, Qatar, Venezuela, Poland, Germany, France, and Italy are among the  nations shoring up their gold reserves” (Moadel). 

From this information, on the one hand, the US Dollar itself indeed has potential collapse  risks; on the other hand, the actions of many countries to increase gold reserves instead of US Dollar  reserves show that the US Dollar will have less influence on the global economy in the future. In conclusion, the US Dollar, as the global currency, plays an important role in the development  of the global economy. It has close connections to many countries across the world, which have  both positive and negative influence on the economy.

US Dollar Hegemony first established after World War II by using the gold-dollar system, then stabilized by using the petrodollar system after  the gold-dollar system failed. Through its development, the US Dollar is essential to many  countries because those countries pegged their domestic currency to the US Dollar, which was also the reason that triggered huge financial crises. For the future of the US Dollar, the foreground of  the US Dollar obtains a short position because of the low-interest rate, high debt ratio, and large  amounts of US Dollar that flows globally.

Written by Gechen Shen

Works Cited 

Amadeo, Kimberly. “Will the Petrodollar Collapse?” The Balance, The Balance, 28 May 2019, 

Chappelow, Jim. “Asian Financial Crisis Definition.” Investopedia, Investopedia, 16 Mar. 2020, 

Chen, James. “Bretton Woods Agreement and System: An Overview.” Investopedia, Investopedia,  29 Jan. 2020, “Effective Federal Funds Rate.” FRED, 20 Mar. 2020, Cheung, Brian. “Fed Makes ‘Aggressive’ Move to Back Corporate Debt Markets, Main St.” Yahoo!  Finance, Yahoo!, 23 Mar. 2020, meeting-announces-unprecedented-moves-to-calm-corporate-debt-120121252.html. Kenton, Will. “Marshall Plan.” Investopedia, Investopedia, 29 Jan. 2020, 

Leong, Richard. “China Sells Most U.S. Treasuries in Nearly Two-and-a-Half Years.” Reuters,  Thomson Reuters, 15 May 2019, sells-most-us-treasuries-in-nearly-two-and-a-half-years-idUSKCN1SL2U4. 

Moadel, David. “Countries Are Buying Gold to Escape the U.S. Dollar.” Crush The Street, 12 Mar.  2019, Picardo, Elvis. “Why China’s Currency Tangos With The USD.” Investopedia, Investopedia, 29  Jan. 2020,“US Gold Reserves vs. US Money.” BullionVault, news/US_gold_reserves_01120092.

What is the Hegemony of the U.S. dollar?