Working Paper: CEPR ID: DP16712
Authors: Javier Bianchi; Saki Bigio; Charles Engel
Abstract: We develop a theory of exchange rate fluctuations arising from financial institutions’ demand for dollar liquid assets. Financial flows are unpredictable and may leave banks “scrambling for dollars.” Because of settlement frictions in interbank markets, a precautionary demand for dollar reserves emerges and gives rise to an endogenous convenience yield on the dollar. We show that an increase in the dollar funding risk leads to a rise in the convenience yield and an appreciation of the dollar, as banks scramble for dollars. We present empirical evidence on the relationship between exchange rate fluctuations for the G10 currencies and the quantity of dollar liquidity, which is consistent with the theory.
Keywords: exchange rates; liquidity premia; monetary policy
JEL Codes: E44; F31; F41; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in dollar funding risk (F31) | rise in convenience yield (G19) |
| rise in convenience yield (G19) | appreciation of the dollar (F31) |
| increase in dollar funding risk (F31) | appreciation of the dollar (F31) |
| liquidity ratio (E41) | dollar's strength (F31) |
| high volatility periods (E32) | appreciation of the dollar (F31) |
| banks scrambling for dollars (G21) | increase in demand for dollars (E41) |
| increase in demand for dollars (E41) | increase in value of the dollar (F31) |