Liquidity Premium, Tariffs and Currency Internationalization

Abstract

Although China, now the world’s second largest economy and largest goods trading nation, has implemented the ambitious currency reform of internationalizing its national currency while maintaining strict capital controls for nearly a decade, the influence of this unique reform path on international economy is uncertain to international economists. This paper is among the first endeavors to contribute to this thread of research from a theoretical perspective. In particular, it develops a two-country, two-currency and two-good model to investigate the implications of currency internationalization on international monetary stability and commodity price system. It shows that to coexist with the international currency, the local currency must be overvalued against its purchasing power parity level to sustain currency internationalization. The tariff of the international currency issuer would loosen the coexistence condition, while the tariff of the local currency issuer would tighten it. If there is no tariff in the developed country, the developing country must maintain a positive tariff rate to sustain its currency internationalization. In particular, full currency internationalization cannot be achieved under the no-tariffs scenario.