The Dollar’s Imperial Circle Ozge Akinci | Gianluca Benigno | Serra Pelin | Jonathan Turek N O . 1 0 45 D E C E M B E R 2 0 2 2 The Dollar’s Imperial Circle Ozge Akinci, Gianluca Benigno, Serra Pelin, and Jonathan Turek Federal Reserve Bank of New York Staff Reports, no. 1045 December 2022 JEL classification: E32, E44, F41 Abstract In this paper we highlight a new channel through which dollar fluctuations can become a self-fulfilling pro-cyclical force. We call this mechanism “Imperial Circle” as it makes the dollar the dominant macroeconomic variable in the context of the current international monetary system. At the core of it, there is a fundamental asymmetry between the shrinking exposure of the “real” U.S. economy to global developments versus the growing global rol e of the U.S. dollar. Dollar appreciation leads to a decline in global economic activity, which in turn benefits, in relative terms, the dollar itself, reinforcing the initial appreciation and its effects. Key words: multi-country DSGE model, global supply chains, dollar currency pricing, trade spillovers _________________ Akinci, Benigno: Federal Reserve Bank of New York (emails: ozge.akinci@ny.frb.org, gianluca.benigno@ny.frb.org). Pelin: University of California at Berkeley (email: serra_pelin@berkeley.edu). Turek: JST Advisors. The authors thank Ethan Nourbash and William Cross-Bermingham for excellent research assistance. This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in this paper are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s). To view the authors’ disclosure statements, visit https://www.newyorkfed.org/research/staff_reports/sr1045.html. 1 IntroductionThe role of the dollar in the context of the international monetary system has been examined andstudied extensively in the recent and distant past. The objective of this research is to focus on therole of the dollar by combining several elements that characterize the structure of the internationalmonetary system and the U.S. economy to highlight a channel through which the dollar exercisesits power in the world economy to make it not only the dominant currency but the dominantmacroeconomic variable (i.e., the Imperial Dollar, Soros (1984) and Turek (2020)).There are two key asymmetries that are central to the mechanism we focus on. The first asym-metry arises from the global use of the dollar in the international monetary system along differentdimensions that exceed the relative size of the U.S. economy within the global economy. The secondasymmetry occurs as the U.S. economy has relatively limited exposure to developments in the worldeconomy compared to its trading partners so that the dollar sensitivity to foreign development issmaller. Indeed, we emphasize how the dollar is a determinant variable in the global manufacturingcycle because of its dominance in trade invoicing (see, for example, Goldberg and Tille (2008b) andGopinath (2016)) and its role in credit intensive global value chains (Bruno and Shin (2021)). Astronger dollar weakens global manufacturing trade and global manufacturing output through thesechannels. Given that the U.S. economy is much less exposed to the global manufacturing cycle andis relatively more service oriented, the dollar tends to benefit from global manufacturing weakness,reinforcing the initial strength and its effect. The combination of structural international and U.S.specific elements creates then a self fulfilling pro-cyclical force that gives rise to what we dub asImperial Circle 2.0 (see, Turek (2020)).To validate our analysis we build a three-country open economy model (Akinci et al. (2022)) inthe tradition of Obstfeld and Rogoff (1995) and extend it to incorporate the key elements behindthe Imperial Circle hypothesis. We interpret our multi-polar economy as representing the U.S., theAdvanced Economy (AE) countries and Emerging Market (EM) economies. As in the DominantCurrency Paradigm (DCP) (Gopinath et al. (2020)), we assume that firms in the EM bloc set pricesin the US dollar while we keep the assumption of producer currency pricing for the AE bloc.1Inaddition to labor, we allow for producers in all countries to use domestic and foreign intermediateinputs in the production process to capture part of the complexity of the integrated internationalproduction processes. To represent the idea of credit intensive global value chain, we assume thatthere is a working capital constraints at the level of intermediate inputs so that firms borrow indollar units to finance advanced inputs payments. Finally, we allow for an asymmetric structure interms of trade exposure of the