Working Paper: NBER ID: w29457
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: International Liquidity; Exchange Rates; Banks; Dollar Funding Risk
JEL Codes: F41; F44; 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 the convenience yield (G19) |
| rise in the convenience yield (G19) | appreciation of the dollar (F31) |
| increase in dollar funding risk (F31) | appreciation of the dollar (F31) |
| liquidity ratio (E41) | value of the dollar (F31) |
| liquidity factors (E41) | variations in euro-dollar exchange rate (F31) |