The Global Dollar Cycle
The U.S. dollar’s nominal effective exchange rate closely tracks global financial conditions, which themselves show a cyclical pattern. Over that cycle, world asset prices, leverage, and capital flows move in concert with global growth, especially influencing the fortunes of emerging and developing economies (EMDEs). This paper documents that dollar appreciation shocks predict economic downturns in EMDEs and highlights policies countries could implement to dampen the effects of dollar fluctuations. Dollar appreciation shocks themselves are highly correlated not just with tighter U.S. monetary policies, but also with measures of U.S. domestic and international dollar funding stress that themselves reflect global investors’ risk appetite. After the initial market panic and upward dollar spike at the start of the COVID-19 pandemic, the dollar fell as global financial conditions eased; but the higher inflation that followed has induced central banks everywhere to tighten monetary policies more recently. The dollar has strengthened considerably since mid-2021 and a contractionary phase of the global financial cycle is now under way. Owing to increases in public- and business-sector debts during the pandemic, a strong dollar, higher interest rates, and slower economic growth will be challenging for EMDEs.
An earlier version of this paper was presented at the September 2022 Brookings Papers on Economic Activity conference and a revised version is scheduled for publication in the Fall 2022 issue of Brookings Papers on Economic Activity. We are grateful to Fernando Eguren-Martin, Zhengyang Jiang, Gian Maria Milesi-Ferretti, Emi Nakamura, Mikkel Plagborg-Møller, Hyun Song Shin, Jón Steinsson, and Mark Watson for helpful discussion; to Victoria de Quadros for outstanding research assistance; and to Egemen Eren, Gordon Liao, Friederike Niepmann, and Jianlin Wang for help obtaining data. Janice Eberly and our discussants, Sebnem Kalemli-Özcan and Matteo Maggiori, provided helpful detailed comments. We also had the benefit of reactions from BPEA conference participants. Obstfeld acknowledges with thanks financial support from the Class of 1958 chair and the Clausen Center at UC Berkeley. Zhou acknowledges generous financial support from the International Economics Section and the Griswold Center for Economic Policy Studies at Princeton University. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.