The 'Exorbitant Privilege': A Theoretical Exposition

This paper develops a general equilibrium model to study how the "exorbitant advantage" works, whether it is sustainable, and what may be the consequences if it is removed. Its main findings are: (1) the center country that issues the reserve currency enjoys the "exorbitant advantage" in the sense that her current account deficit can be financed by the periphery country¡¯s reserve holdings. The "exorbitant privilege" is predicated on the overvaluation of the reserve currency caused by a higher rate of money growth in the center country; (2) the "exorbitant advantage" is not likely to be sustainable in the long run; (3) if the "exorbitant advantage" is removed, the value of the reserve currency will depreciate, the terms of trade will change against the periphery country and sector composition will change in favour of the tradable sector in the center country and in favour of the non-tradable sector in periphery country. These changes will be more pronounced if the center country repays her debt by printing money instead of raising taxes.