The Dollar During the Global Recession: US Monetary Policy and the Exorbitant Duty
Since the US dollar is the world’s dominant currency, the United States benefits from the “exorbitant privilege” of paying low interest rates on safe (risk-free) dollar-denominated assets, such as the bonds issued by the US government. When global risk aversion is elevated, investors tend to hedge against uncertainty by switching to dollar-denominated assets, a form of insurance termed the “exorbitant duty” that comes with serving as the world’s reserve currency.
While the international macroeconomics literature has a clear understanding of the flight-to-safety effects imposed upon the United States during crises, it provides no answers about what types of exogenous shocks trigger the dollar’s exorbitant duty behavior and by what channels these shocks are transmitted. The authors study how the US dollar responded to the Fed’s monetary policy actions during the Global Recession, defined as 2008:Q4 through 2012:Q2, and find that Fed easings during this period actually led the dollar to appreciate, thus triggering its “exorbitant duty” in a way that runs counter to conventional wisdom. The authors use a novel decomposition of the exchange rate response to study the channels that led to this appreciation and propose a theoretical model that reconciles and explains these novel findings.