VoxEU Column Financial Markets Exchange Rates

Dollar dominance and the international adjustment to global risk

In times of heightened global risk, investors flock to the dollar as their capacity or willingness to bear risk declines. As a result, the dollar appreciates. This column examines the effects of global risk shocks and the dollar’s role in the international adjustment to such shocks, finding that appreciation of the dollar amplifies the adverse effect of global risk shocks considerably. Policies that stabilise the dollar in the face of global risk, such as the liquidity provision by the Federal Reserve in response to the COVID-19 pandemic, can help stabilise global economic activity.

The US and the dollar play a special role in the global economy, both for trade and for financial flows (Rey 2013, Maggiori et al. 2018, Gopinath 2020). The dollar’s dominance also manifests itself in times of elevated global risk. Figure 1 illustrates this for the Global Financial Crisis and the early stage of the COVID-19 pandemic in March 2020. In both instances, global risk, measured by the VIX, increases sharply while the dollar appreciates strongly. At a theoretical level, co-movement between the dollar and measures of global risk can be rationalized on the ground that some US assets are particularly safe and/or liquid (Farhi and Gabaix 2016, Bianchi et al. 2021, Jiang et al. 2021a). But what are the consequences of the dollar’s dominance for the international adjustment to global risk shocks? Does the dollar appreciation dampen or amplify their adverse effects on the global economy?

Figure 1 The US dollar exchange rate and the VIX


Notes: VIX is an index of expected stock market volatility compiled by Chicago Board of Options Exchange; dollar exchange rate is the price of dollar expressed in foreign currency (in effective terms) such that an increase represents an appreciation.

International adjustment to global risk shocks

In a new paper, we shed light on this question as we identify global risk shocks and trace out their effect on the global economy, with a focus on the dollar (Georgiadis et al. 2021). Global risk shocks are incidents that are associated with an increase in the demand for safe and liquid assets. We measure their effect on the global economy within an estimated Bayesian proxy structural VAR model. We identify global risk shocks using intra-daily changes in the price of gold – the ultimate safe asset – as recorded on narratively selected dates related to global risk events as an external instrument (Piffer and Podstawski 2018, Engel and Wu 2018, Ludvigson et al. 2021).

We find that although global risk shocks cause a contraction of economic activity that is highly synchronised in the US and the rest of the world, they cause a strong appreciation of the dollar. We also document that global risk shocks induce flight-to-safety effects as foreign holdings of US Treasury securities increase, an uptick in the US Treasury premium, an increase in the dollar liquidity buffers of banks, and an increase in the share of dollar-denominated international debt issuance. 

What if the dollar didn’t appreciate?

We then investigate how the dollar shapes the transmission of global risk shocks, especially the contraction of economic activity outside of the US. In theory, the effect of dollar appreciation is ambiguous. On the one hand, appreciation of the dollar dampens the adverse impact of global risk shocks in the rest of the world via a trade channel, as it induces expenditure switching from the US towards the rest of the world (Obstfeld and Rogoff 1995, Gopinath et al. 2020). On the other hand, dollar appreciation may amplify the adverse impact of global risk shocks in the rest of the world via a financial channel, as it deteriorates the net worth of borrowers that are subject to currency mismatches and thereby induces a tightening in global financial conditions (Bruno and Shin 2015, Jiang et al. 2021a). Indeed, we find that global risk shocks that appreciate the dollar are followed by a decline in US net exports and a broad-based tightening in global financial conditions reflected, in particular, in a contraction in cross-border bank credit. But this doesn’t tell us whether the dollar appreciation overall dampens or amplifies the effects of global risk shocks outside of the US.

We therefore set up a counterfactual in which we simulate the effects of a global risk shock that would materialise in the absence of a dollar appreciation. Formally, we follow a minimum relative entropy (MRE) approach to construct the counterfactual: we use the posterior distribution obtained from the Bayesian estimation to determine a counterfactual in which (a) the dollar does not respond to global risk shocks, but which (b) is otherwise as similar as possible to the model generating the data. By comparing the actual to the counterfactual outcome, we can assess the dollar’s overall contribution to the international transmission of global risk shocks.

Figure 2 shows the results. The blue lines represent the estimates for the baseline model which features dollar appreciation (upper-left panel). The red lines with circles show the adjustment to global risk shocks when there is no dollar appreciation (i.e. the counterfactual). We find that the contraction in the rest of the world is roughly halved in the counterfactual. The upper-middle and upper-right panels shows the response of industrial production in the US and in the rest of the world (RoW), respectively. The bottom panels show that in the counterfactual US net exports and (especially dollar-denominated) cross-border bank credit flows to non-US borrowers contract less in response to the global risk shock. All else equal, the first effect amplifies the slowdown of economic activity in the rest of the world, while the second effect dampens it. Hence, given that the contraction is smaller in the absence of dollar appreciation, we conclude that the financial channel dominates the trade channel – overall, dollar appreciation amplifies the adverse effects of global risk shocks. 

Figure 2 Effects of a global risk shock with and without dollar appreciation


Note: Horizontal axis measures time in months, vertical axis measures deviation from pre-shock level; size of shock is one standard deviation; blue solid line represents point-wise posterior mean and shaded areas 68%/90% equal-tailed, point-wise credible sets. Red circled line depicts point-wise means of the counterfactual posterior distribution obtained from the MRE approach.

US monetary policy 

Our analysis of the special role of the dollar for the transmission of global risk also sheds light on the developments in global financial markets during the COVID-19 pandemic, notably on the Federal Reserve’s (Fed) unprecedented liquidity support to emerging economies. In principle, Fed swap lines provide safe assets by crediting rest-of-the-world central banks with dollar reserves. To the extent that this reduces the Treasury convenience yield this, in turn, will dampen appreciation pressures on the dollar (Jiang et al. 2021a, b). And Figure 1 above indeed suggests that the appreciation of the dollar in early 2020 was fairly short lived – if benchmarked against our estimates of the average effect of a global risk shock (as shown in Figure 2).

We thus explore whether stabilisation of the dollar that resulted as a side effect of the Fed’s emergency liquidity provision may have helped to prevent an even more pronounced slowdown of the world economy. Specifically, in our time-series framework, we use a sequence of identified monetary policy shocks that perfectly stabilizes the dollar in the face of a global risk shock. Of course, this exercise should be understood only as an approximation to the more complex reality of the Fed’s interventions. Consistent with the exceptional nature of the emergency liquidity provision by the Fed, Figure 3 shows that in order to stabilise the dollar, US monetary policy is loosened much more compared to what is observed in normal times (see the response of the 1-year Treasury bill rate in the left panel of Figure 3). Crucially, in this counterfactual, economic activity outside of the US slows much less (right panel of Figure 3). This suggests that without the Fed’s emergency liquidity provision in early 2020 the slowdown of the world economy would have indeed been substantially more pronounced, in line with arguments put forward elsewhere (Cetorelli et al. 2020). 

Figure 3 Baseline and structural shock counterfactual responses to a global risk shock based on US monetary policy shocks as offsetting shocks



Note: See the note to Figure 2. 1Y-TB indicates the 1-year Treasury bill rate.


Bianchi, J, S Bigio, and C Engel (2021), “Scrambling for dollars: International liquidity, banks and exchange rates”, mimeo.

Bruno, V and H S Shin (2015), “Capital flows and the risk-taking channel of monetary policy”, Journal of Monetary Economics 7(C): 119-132.

Cetorelli, N, L Goldberg, and F Ravazzo (2020), “Have the fed swap lines reduced dollar funding strains during the COVID-19 outbreak?”, New York Fed Liberty Street Economics blog, 22 May.

Engel, C  and S P Y Wu (2018), “Liquidity and exchange rates: An empirical investigation”, NBER Working Paper 25397.

Farhi, E and X Gabaix (2016), “Rare disasters and exchange rates”, Quarterly Journal of Economics 131(1): 1–52.

Georgiadis, G, G J Müller, and B Schumann (2021), “Global risk and the dollar”, CEPR Discussion Paper 16245.

Gopinath, G (2020), “The dominance of the US dollar in trade and finance”,, 29 June.

Gopinath, G, E Boz, C Casas, F Diez, P-O Gourinchas, and M Plagborg-Moller (2020), “Dominant currency paradigm”, American Economic Review 110(3): 677-719.

Jiang, Z, A Krishnamurthy, and H Lustig (2021a), “Dollar safety and the global financial cycle”, mimeo.

Jiang, Z, A Krishnamurthy, and H Lustig (2021b), “Foreign safe asset demand and the dollar exchange rate”, Journal of Finance 76(3): 1049-1089.

Ludvigson, S, S Ma, and S Ng (2021), “Uncertainty and business cycles: Exogenous impulse or endogenous response?”, American Economic Journal: Macroeconomics 13(4): 369-410.

Maggiori, M, B Neiman, and J Schreger (2018), “The rise of the dollar and fall of the euro in global asset trade”,, 18 June.

Obstfeld, M and K Rogoff (1996), Foundations of international macroeconomics, The MIT Press.

Piffer, M and M Podstawski (2018), “Identifying uncertainty shocks using the price of gold”, Economic Journal 128(616): 3266-3284.

Rey, H (2013), “Dilemma not Trilemma: The global financial cycle and monetary policy independence”,, 31 August.

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