Gita Gopinath | Macro Paper Warehouse

Central Banks as Dollar Lenders of Last Resort: Implications for Regulation and Reserve Holdings

Thu, 01 Jan 2026 00:00:00 +0000

This paper investigates why non-U.S. central banks accumulate large holdings of dollar-denominated foreign exchange reserves, focusing on a previously under-emphasized motive: the currency mismatch of private-sector non-financial firms. When domestic firms borrow heavily in dollars despite having predominantly local operating revenues, the central bank faces potential liability as a dollar lender of last resort (DOLLR) in the event of a banking crisis coinciding with a dollar appreciation. The paper combines motivating empirical evidence with a formal theoretical model to analyze the optimal policy mix between ex ante financial regulation (bank capital requirements) and ex post reserve accumulation, and then extends the model to characterize global externalities arising from decentralized reserve-holding decisions.

A Conceptual Model for the Integrated Policy Framework

The Mundell-Fleming benchmark says a flexible exchange rate plus a standard interest-rate rule fully insulates a small open economy, and this paper asks what that prescription survives once the world’s actual imperfections are added. It builds a three-period small open economy – households, a government, tradable-goods firms, housing-sector firms, domestic banks, and international financial intermediaries partly owned by domestic households – and gives a constrained social planner with full commitment four instruments: the policy rate, taxes or subsidies on capital inflows, sterilized FX intervention, and macroprudential taxes on domestic bank lending to households and to housing firms. Each can be used ex ante, in period 0 before a shock, or ex post, in period 1 after one. Countries differ along seven characteristics – currency of trade invoicing, commodity export share, stock of debt, currency mismatch, external debt limit, depth of FX markets, and housing-sector debt limit – and are hit by six shocks: productivity, commodity prices, the world interest rate, the external debt limit, foreign risk appetite, and the housing debt limit. The frictions are deliberately layered. Export prices are sticky either in the producer’s currency (PCP) or in a dominant currency (DCP), motivated by the observation that “many emerging markets have dollar invoicing shares above 80 percent.” An occasionally-binding constraint caps domestic banks’ external debt at a fraction of the domestic tradable price, in the spirit of Mendoza (2010), Bianchi (2011) and Farhi and Werning (2016); another caps housing firms’ debt at a fraction of their land value, following Kiyotaki and Moore (1997); and asset-market segmentation following Gabaix and Maggiori (2015) means intermediaries have limited capacity to bear the country’s currency exposure, so uncovered interest parity fails – the paper’s “shallow FX markets.” Five externalities follow: the standard Keynesian aggregate demand externality, a terms-of-trade externality the authors deliberately downplay and sometimes parameterise away, a pecuniary aggregate demand externality from the banks’ constraint interacting with currency mismatch, a pecuniary production externality in housing, and a financial terms-of-trade externality that exists only when FX markets are shallow. The results are a mapping from shock-and-characteristic combinations to instrument settings rather than a set of point estimates: this is a conceptual model illustrated by simulations, and it reports directions, signs and comparisons across regimes rather than calibrated magnitudes. Flexible exchange rates remain optimal for a class of cases, including under DCP when there are no financial frictions – though the DCP economy then needs larger exchange rate movements to do the same stabilising work. Financial frictions are what break the benchmark: when future shocks can make the banks’ constraint bind, prudential capital controls are warranted in normal times; capital controls and macroprudential consumer taxes are perfect substitutes only when the macroprudential perimeter covers the whole economy; FX sales and looser inflow taxes both buy monetary autonomy after a foreign-appetite shock, and buy more of it used together; and housing and external constraints can each trigger the other, so ex-ante housing macroprudential taxes may be needed in anticipation of external as well as domestic shocks. Three broad principles close the analysis: instruments are not interchangeable and a newly available tool may simply be the wrong one; instruments affect multiple imperfections, so adding one can raise or lower the use of another; and there is no strict assignment of domestic tools to domestic shocks or external tools to external shocks.

Banking, Trade, and the Making of a Dominant Currency

This paper argues that a currency’s role as the unit of account in which international trade is invoiced and its role as a safe store of value are complementary, and that the feedback between them can entrench a single dominant currency even between economies with identical fundamentals. The starting observation is that a financial claim is only meaningfully safe if it buys a known quantity of goods, so if a household’s imports are priced in dollars and those dollar prices are sticky, dollar deposits are its safest asset in real terms. Demand for safe dollar claims therefore rises with the dollar invoice share. Beyond what the US Treasury supplies, the marginal safe dollar claim must be manufactured by banks in other countries – and those banks’ collateral is local-currency project revenue, which backs dollar promises inefficiently because the local currency can depreciate. In the model’s collateral constraint, an amount of local collateral sufficient to back one unit of safe local-currency claims backs only 1/E-bar units of safe dollar claims, where E-bar is the most depreciated exchange rate. Firms with the inferior technology can only be drawn into producing dollar collateral if they are paid for it, that is, if dollar borrowing is cheaper than local-currency borrowing – so the dollar’s “exorbitant privilege” emerges endogenously as the price that clears the market for safe dollar claims, with Proposition 1 pinning the wedge exactly at (Q-dollar minus beta)/(Q-home minus beta) = E-bar. This reverses the usual informal reasoning: rather than taking the uncovered-interest-parity violation as exogenous and using it to explain why foreign firms borrow in dollars, the paper takes the dollar invoice share as the primitive and derives the UIP violation from it. The paper then closes the loop in three steps. Letting exporters choose their invoice currency at a quadratic cost, the first-order condition makes the dollar-invoiced share proportional to the UIP gap, so any positive dollar premium induces some dollar invoicing, because more predictable dollar revenues are better collateral for cheap dollar borrowing. Embedding this in a continuum of emerging markets whose dollar invoice share is an anchor plus a feedback coefficient times other countries’ invoicing choices generates strategic complementarity, multiple equilibria when the feedback is strong, and a discrete jump in the dollar’s global role as the US share of emerging-market imports gradually rises. Finally, putting a symmetric euro alongside the dollar – equal external safe-asset supply, equal exchange rate volatility, symmetric invoicing costs – yields asymmetric dominant-currency equilibria in which one currency is used heavily for both invoicing and bank funding and the other is not used at all, with an intermediate parameter range where a single dominant currency is the only possible outcome. The model cannot say which currency wins (“taken literally, the model says that the outcome is indeterminate”), so the authors propose history as the selection device. The empirical work is explicitly preliminary: across the ten countries with both import-invoicing and BIS locational banking data, the dollar’s share of foreign-currency bank liabilities lines up strongly with the dollar’s share of foreign-currency-invoiced imports, with a regression R-squared of 0.72, rising to 0.82 on the eight countries for which the liability measure can be narrowed to loans and deposits from non-bank counterparties. Throughout, the authors are candid about the model’s simplifications: exchange rates are exogenous with no expected appreciation, the money-demand formulation is described as “arguably an ad-hoc way” of capturing invoice-currency safety, the central bank reserve link is asserted rather than modelled here, and the analysis speaks to average cross-currency return differentials rather than to higher-frequency phenomena like the forward premium puzzle.

Dominant Currency Paradigm

Standard open-economy macro models assume that export prices are sticky either in the producer’s currency, in which case a depreciation improves the terms of trade and competitiveness, or in the destination’s currency, in which case it worsens them. Neither matches the invoicing evidence: the vast majority of world trade is priced in a small number of dominant currencies, with the dollar playing an outsized role. This paper builds an alternative “dominant currency paradigm” from three joint ingredients – infrequently adjusted prices set in a dominant currency, strategic complementarities in pricing that make desired markups variable, and roundabout production using imported inputs – and derives four sharp testable implications: the bilateral terms of trade should be insensitive to bilateral exchange rates; for non-US countries import price pass-through should be high but driven by the dollar rather than the bilateral exchange rate, and more so the higher the country’s dollar invoicing share; import quantities should likewise be driven by the dollar rate, with US import quantities much less responsive; and a uniform appreciation of the dollar should reduce trade among countries other than the United States. The tests use two new datasets: bilateral non-commodity price and volume indices built from UN Comtrade for more than 2,500 country pairs covering 91 percent of world trade, 1992-2015, and firm-10-digit-product-country-quarter customs records for Colombia, an economy that invoices 98 percent of its exports in dollars. All four implications hold. Regressing bilateral terms of trade growth on bilateral exchange rate growth gives a contemporaneous coefficient of 0.037 with a 95 percent confidence interval of [0.02, 0.05], against a predicted 1 under producer currency pricing and −1 under local currency pricing, and the coefficient shrinks further toward zero once relative producer prices are controlled for. A standard bilateral pass-through regression implies near-complete pass-through – a 10 percent depreciation of the importer’s currency against the exporter’s raises import prices about 8 percent within the year – but adding the dollar exchange rate and time fixed effects knocks the bilateral coefficient from 0.76 to 0.16, with the dollar coefficient at 0.78 absorbing almost all of it, and raising a country’s dollar invoicing share by 10 percentage points raises contemporaneous dollar pass-through by 3.5 to 7.6 percentage points. On volumes the contemporaneous dollar elasticity is roughly −0.19 to −0.13 while the bilateral elasticity is an order of magnitude smaller; the euro is far less important than the dollar in both sets of regressions. Consistent with 97 percent of US exports and 93 percent of US imports being dollar-invoiced, bilateral pass-through into US export prices is complete on impact and close to zero for US import prices, and US import volumes are essentially unresponsive to the bilateral exchange rate (an implied 0.003 percent contemporaneous response to a 1 percent dollar depreciation, against −0.12 percent for non-US importers), so US trade balance adjustment runs through exports rather than imports. Aggregating the bilateral panel, a 1 percent ceteris paribus dollar appreciation against all other currencies predicts a 0.6 percent contraction in rest-of-world trade volume within the year, persisting for at least two years, controlling for proxies for the global business and financial cycles; dollar pass-through into foreign CPI and PPI averages 11 and 28 percent within the year and rises with the dollar invoicing share. The Colombian microdata reproduce all of this and additionally let the authors estimate the model: the estimated invoicing shares are essentially DCP, the estimated model tracks the observed dynamics of pass-through while PCP and LCP counterfactuals do not, and removing strategic complementarities and imported inputs halves four-quarter export pass-through from 65 to 30 percent. The authors are explicit about interpretation: the volume regressions “do not capture structural demand elasticity parameters” and “conflate expenditure switching and shifts in aggregate import demand,” so they are predictive relationships rather than structural estimates; and the invoicing currency is taken as given, with the argument that the model’s own ingredients are the ones that would generate dominant-currency pricing endogenously.