Dollar appreciation in periods of high global risk

The impact of dollar appreciation: the trade and financial channels

What is the impact of dollar appreciation on the transmission of global risk? Does it help the world economy in coping with global risk shocks or does it amplify their adverse impact? This is the question that Georgiadis et al. address in this paper. Toward this end, the authors examine two channels through which the dollar appreciation affects the global economy: a) the trade channel, through which the dollar appreciation induces expenditure switching in the Rest of the World (RoW) as US net exports fall; b) the financial channel, through which global equity prices drop, spreads increase and cross-border bank credit contracts. They construct three conceptually different counterfactuals that simulate the effects of a global risk shock in the absence of dollar appreciation.

• The first counterfactual is based on an estimated VAR model and explores the most likely path of the endogenous variables (US industrial production, the 1-Treasury bill rate, the excess bond premium, consumer prices,  the dollar nominal effective exchange rate, the 5-Treasury bill rate, the VXO, RoW industrial production and policy rates) conditional on a global risk shock in a scenario in which the dollar happens to not appreciate because additional, offsetting shocks materialize as well.
• The second counterfactual is a VAR-based policy-rule experiment assuming that conditional on a global risk shock the Federal Reserve stabilized the dollar exchange rate.
• The third counterfactual is based on a structural model for the US and the RoW in which the deep parameters can be modified so that the dollar does not hold a dominant status in cross-border credit and safe assets which are responsible for the appreciation upon a global risk shock in the first place.

We find that in all counterfactuals the contraction in activity caused by a global risk shock is substantially smaller both in the US and the RoW. Without dollar appreciation the response of US net exports hardly changes, while global financial conditions tighten much less. The contractionary effects of the dollar appreciation that materialize through tighter financial conditions thus dominate expansionary effects through expenditure switching.

Global risk and the dollar
Authors: Georgios Georgiadis, Gernot J. Müller, Ben Schumann
From: European Central Bank, University of Tübingen, DIW Berlin and Free University of Berlin

The impact of dollar appreciation:  the “flight to safety” channel

In this paper, Bodenstein et al. develop and estimate a macroeconomic model of the world economy featuring time variation in agents’ preferences for safe assets, in which a component of this variation can be global and biased toward dollar-denominated safe assets. It’s the variation in agents’ preference for safe bonds, that captures the global-flight-to-safety (GFS) shocks. Their central findings are:

• GFS shocks explain almost forty percent of the variation in world GDP growth, far more than any other shock category, and are also key drivers of fluctuations in activity in the U.S. and particularly abroad.
• The authors do not find a significant role of U.S. monetary shocks in driving foreign developments or in generating international co-movement.
• Adverse GFS shocks are associated with lower U.S.  and foreign interest rates, not higher.

Global Flight to Safety, Business Cycles, and the Dollar
Authors: Martin Bodenstein, Pablo Cuba Borda, Nils Gornemann, Ignacio Presno, Andrea Prestipino, Albert Queralto, and Andrea Raffo
From: Federal Reserve Board, Federal Reserve Bank of Minneapolis