This paper proposes a novel transmission channel of US monetary policy through FX swap markets: the synthetic dollar funding channel. First, I empirically show that a contractionary US monetary policy shock widens deviations from covered interest rate parity (CIP) in the post-global financial crisis period. To explain this, I develop a two-country New Keynesian model with an FX swap market, where US banks supply synthetic dollar funding by arbitraging CIP deviations while non-US banks demand it for currency matching. CIP deviations arise since US banks face limits on arbitrage. The calibrated model shows that a contractionary US monetary policy shock widens CIP deviations by tightening these limits on arbitrage and increasing the shadow cost of balance sheet space. Compared to a counterfactual scenario where CIP holds, macroeconomic spillovers and spillbacks are amplified because the widening of CIP deviations functions as a financial accelerator. Finally, I show that central bank swap lines attenuate the synthetic dollar funding channel.
Presentation: KAEA Job Market Conference (Excellence Award), Annual Carey Finance Conference, WashU Economics Graduate Student Conference, Asia Meeting of the Econometric Society in East & Southeast Asia, Federal Reserve Board Dissertation Fellowship Seminar, 23rd Macro-Finance Society Workshop
This paper studies the optimal central bank swap line policy. Due to a pecuniary externality, there is a trade-off between ex-ante and ex-post efficiency of the swap line policy. During financial crises, the swap line policy lowers CIP deviations and prevents fire sale of source currency assets, beneficial to both recipient and source country. However, it makes recipient banks to overborrow ex-ante, sowing the seeds of financial crises. From a global welfare point of view, the ex-post efficient policy is more lenient than the ex-ante efficient policy, which implies time inconsistency. The policy mix with macroprudential policies can correct the overborrowing problem and resolve time inconsistency. Moreover, policy coordination of a cooperative Ramsey problem obtains undersupply (oversupply) of source currency provision under a realistic condition when the source country has higher (lower) bargaining power.
Presentation: Federal Reserve Board Brownbag Seminar
This paper investigates effects of domestic and foreign monetary policy under dominant currency pricing and dominant currency financing. For this purpose, I construct a small open economy New Keynesian model with a working capital constraint. Due to the need for working capital for importing intermediate inputs, dominant currency pricing and dominant currency financing are complementary. Under the working capital constraint, the depreciation of the dominant currency is not sufficient for predicting trade volume. Even though both the expansionary domestic monetary policy and the contractionary foreign monetary policy lead to the depreciation of the domestic currency, trade volume move in the opposite direction since monetary policy affects marginal costs through working capital constraint. Finally, I extend the model by including non-tradable sectors, which amplifies the response of trade volume to monetary policy shock since profits of non-tradables are not insulated from the depreciation.