Consumption, exchange rate, and external adjustment during a crisis

I develop a two-country open economy model featuring asymmetric financial frictions to explain two puzzling observations during the 2008 global financial crisis: (1) real consumption growth declined more in foreign countries than in the US, despite the crisis originating in the US, and (2) the US dollar appreciated against foreign currencies despite a significant deterioration in the US net foreign asset position. Subject to a less stringent financial constraint, the US tends to hold more risky assets relative to foreign countries in tranquil times, thereby exposing itself more to financial risks. As the crisis unfolds, the US incurs greater capital losses and is forced to liquidate its risky asset holdings to deleverage. This deleveraging process triggers a capital retrenchment in the US, thereby smoothing US consumption and prompting a US dollar appreciation. Consequently, this model challenges the “exorbitant duty” hypothesis and provides insights into the “reserve currency paradox”.