Working Paper

Scrambling for Dollars: International Liquidity, Banks and Exchange Rates

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 Classification: E44; F31; F41; G20;

https://doi.org/10.21034/wp.786

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Working Papers

Publication Date: 2021-11-05

Number: 786