Payment Frictions, Capital Flows, and Exchange Rates

Cross-border payments are changing: existing intermediaries are upgrading their networks and new platforms based on novel digital forms of money are being explored, even as geoeconomic fragmentation is introducing new frictions. We develop a stylized model to assess the potential implications for the level and volatility of capital flows and exchange rates. On levels, we find that lower frictions in cross-border payments reduce UIP deviations and increase capital flows. On volatility, we find that the impact of lower frictions depends on the type of shock and the degree to which frictions decline. For real shocks, lower frictions increase capital flow volatility and reduce exchange rate volatility. For financial shocks, lower frictions increase exchange rate volatility while the impact on capital flow volatility is ambiguous. Specifically, when frictions decline by a small amount, capital flow volatility increases, while the opposite holds when the reduction in frictions is large. An increase in frictions reverses these results.