Collateral Advantage: Exchange Rates, Capital Flows, and Global Cycles

We construct a two-country New Keynesian model in which the U.S. enjoys an “exorbitant privilege” as its government bonds are desired by banks both in the U.S. and abroad as superior collateral. In times of global stress, the dollar appreciates since the demand for high quality collateral drives up the “convenience yield” earned by U.S. government bonds. There is “retrenchment” - each country reduces its holdings of foreign assets - a critical determinant of which is the endogenous response of prices and returns. The model can account for the observed exchange rate and external position behavior of the U.S. While the model incorporates only a small change from a workhorse New Keynesian model with segmented financial markets, it synthesizes and reconciles three major perspectives: on exorbitant privilege, global financial intermediation, and convenience yields.