Exchange Rate Dynamics and Monetary Spillovers

Exchange Rate Dynamics and Monetary
Spillovers with Imperfect Financial Markets

Özge Akıncı
Federal Reserve Bank of New York, USA
Downloaded from https://academic.oup.com/rfs/article/37/2/309/7318229 by guest on 19 February 2024

Albert Queralto
Federal Reserve Board, USA
We develop a quantitative model with imperfections in domestic and international financial

markets that generates strong effects of U.S. monetary policy on emerging markets
(EMs). Financial imperfections prevent arbitrage both between local EM lending and
borrowing rates, and between local-currency and dollar borrowing rates. An adverse
feedback effect between financial health and external conditions amplifies the domestic
“financial accelerator,” leading to large cross-border spillovers of U.S. monetary policy
shocks. The model implies a link between uncovered interest parity violations and local
credit spreads, a prediction we show the data strongly supports. (JEL E32, E44, F41)
Received January 20, 2021; editorial decision May 14, 2023 by Editor Stefano Giglio.
Authors have furnished an Internet Appendix, which is available on the Oxford University
Press Web site next to the link to the final published paper online.
The effects on foreign economies of monetary policy shifts in the United States,
often referred to as “spillovers,” are the subject of increasing attention. The
financial media regularly publishes stories highlighting global reverberations
from Federal Reserve decisions, and foreign policy makers often express
concern about the impact of U.S. monetary policy on their own economies.1
A fast-growing empirical literature quantifies the effects of U.S. monetary
shocks on foreign countries’ financial and economic developments. A common
We thank Chris Erceg for many fruitful discussions that inspired much of this work, as well as Gianluca
Benigno, Jordi Galí, Sebnem Kalemli-Ozcan, and Paolo Pesenti for very useful comments. Special thanks to
our discussants Giancarlo Corsetti, Tommaso Monacelli, Jenny Tang, Luca Fornaro, Emine Boz, Ambrogio
Cesa-Bianchi, Oleg Itskhoki, and Stephanie Schmitt-Grohé for very helpful suggestions. We also thank seminar
participants at various institutions for their comments. Mike McHenry, Serra Pelin, and Mikael Scaramucci
provided outstanding research assistance. The views expressed in this paper are those of the authors and do not
necessarily reflect the position of the Federal Reserve Bank of New York, the Board of Governors of the Federal
Reserve, or the Federal Reserve System. Supplementary data can be found on The Review of Financial Studies
web site. Send correspondence to Albert Queralto, albert.queralto@frb.gov.
1 For example, in 2018 Urjit Patel, then-Governor of the Reserve Bank of India, urged the Fed to slow its plans
to shrink its balance sheet, arguing that the current plans would contribute to turmoil in emerging markets (Patel
2018). See Bernanke (2017) for a first-hand account of other examples.
The Review of Financial Studies 37 (2024) 309–355

Published by Oxford University Press 2023. This work is written by US Government employees and is in the
public domain in the US.
https://doi.org/10.1093/rfs/hhad078 Advance Access publication October 16, 2023
The Review of Financial Studies / v 37 n 2 2024
finding in this literature is that these spillovers can be substantial, particularly

on emerging market economies (EMs henceforth).2
One prominent theme in the empirical literature, highlighted in influential
work by Miranda-Agrippino and Rey (2020), is that a major channel of
spillovers is through financial conditions. In this view, monetary policy actions
in the United States exert powerful effects on asset prices and financial
intermediaries around the globe. When the Federal Reserve tightens policy,
global asset prices decline, foreign currencies depreciate sharply against

the dollar, and financial constraints tighten in foreign economies. These
developments occur in reverse when the Fed eases. A detailed analysis of
Turkish data by Giovanni et al. (2022) provides additional evidence on these
patterns, by showing that these global effects feed into emerging markets’
local credit conditions, ultimately affecting the cost of credit facing local
nonfinancial borrowers. These authors also document systematic, time-varying
violations of uncovered interest parity (UIP): the premium on the cost of credit
in local currency relative to the cost of dollar credit, which is typically positive,
tends to be larger when overall financial conditions are tight.
In this paper we develop a two-country quantitative macroeconomic model
that can account for substantial spillovers of U.S. monetary policy, in which
imperfections in both domestic and international financial markets play a key
role. We show that the model can generate strong effects of U.S. monetary
policy shocks on (a) the prices of assets in EMs; (b) the tightness in EM
financial conditions, as measured by the credit spread facing local nonfinancial
borrowers; (c) large movements in the local currency relative to the dollar,
driven in part by an endogenous deviation from UIP that widens when the Fed
tightens; and (d) considerable effects on EM gross domestic product (GDP).
Our model can thus capture the salient facts uncovered by the papers referenced
above, including the response of non-U.S. asset prices, credit conditions, and
UIP premiums to U.S. monetary policy shifts. In addition, our framework is
able to capture the implications for real economic activity of these financial
developments.
A key aspect of our theory is a failure of UIP. This failure arises because
financial imperfections limit the ability of EM borrowers to obtain foreign-
currency denominated financing.3 More specifically, EM banks (meant to
capture financial intermediaries broadly defined) borrow in both domestic
and international capital markets to finance domestic investments. The
domestic capital market consists of local currency-denominated loans, and
the international market operates in dollar-denominated loans. Both forms of
external financing are subject to agency frictions. Further, these frictions are
more severe for funds of foreign origin, effectively making the local asset less
2 Examples include Rey (2015), Bruno and Shin (2015a), Dedola, Rivolta, and Stracca (2017),
Iacoviello and Navarro (2018), Bräuning and Ivashina (2020), and Miranda-Agrippino and Rey (2020).
3 From here on, we refer to the emerging market economy as “home,” and to the United States as “foreign.”
310
Exchange Rate Dynamics and Monetary Spillovers with Imperfect Financial Markets
valuable as collateral against dollar loans than against domestic-currency loans.

The two forms of financing are thus imperfect substitutes, a property that leads
to a failure of UIP. The failure of UIP takes a specific form: we show that the
model predicts that the UIP premium (defined as the premium on the local safe
rate relative to the dollar safe rate, inclusive of expected dollar appreciation
vis-á-vis the local currency) is positively linked to the expected yield on the
local risky asset in excess of the local safe rate, that is, the local credit spread.
In the empirical section of the paper, we test this model prediction extensively

using EM data, and find strong support for it. In general equilibrium, we show
that both the credit spread and the UIP premium are inversely linked to EM
banks’ net worth.
We embed the financial imperfection just described within a conventional
New Keynesian production economy and use our framework to study the
spillover effects of U.S. monetary policy shocks on the EM. We find that the
model predicts considerable effects of U.S. policy shifts on emerging market
GDP, consistent with the evidence, largely because of the presence of the
financial imperfection. The main mechanism works as follows. A tightening
of U.S. monetary policy triggers losses in EM borrowers’ balance sheets.
This happens for two reasons. First, given the presence of some balance sheet
mismatch on the part of EM banks (as their assets are denominated in local
currency, while some of their debt is in dollars) the local currency depreciation
triggered by the tightening raises the real burden of the dollar-denominated
debt, reducing banks’ net worth. Second, the depreciation also creates some
increase in local real interest rates, because total expected inflation falls as the
exchange rate is expected to appreciate, also creating some drag in investment
spending and in local asset prices.
Weaker local balance sheets then initiate powerful feedback effects. Balance
sheet deterioration raises the agency costs of external finance. The local
lending spread increases as a result, making credit more expensive for local
borrowers and triggering declines in investment and in the price of capital
(or Tobin’s q), and ultimately slowing activity. These developments then
feed back into borrowers’ financial positions, weakening them further. These
feedback effects operating through domestic conditions are well-known in
the literature, and usually referred to as the “financial accelerator” following
Bernanke, Gertler, and Gilchrist (1999).
Our model adds a second set of feedback effects, based on the interaction
between balance sheets and external conditions, that amplifies the domestic-
based financial accelerator. A weakening of local balance sheets widens the
UIP premium on the local currency, which is accommodated via a depreciation
of the latter against the dollar. Because local balance sheets are partly
mismatched, a weaker local currency then feeds into balance sheet health,
further weakening it, and once again initiating both rounds of feedback. The
end result is sharply amplified declines in local investment, asset prices, and
exchange rates, and ultimately GDP (through a large contraction in investment
311
demand). Given the strength of these feedback mechanisms, the amount of

amplification of U.S. monetary shocks is considerable despite a relatively
modest degree of balance sheet mismatch (for the typical borrower in the
model, the majority of debt is still denominated in local currency, consistent
with the available data from EMs).
A key prediction of our model that lies at the core of the aforementioned
financial amplification channel is that the UIP premium is tied to the local
credit spread. We test this prediction using monthly data for several EMs for

the period from 2000 to 2022. To do so, we estimate a version of the forward-
looking exchange rate equation predicted by our model, in which we include
proxies for the local credit premium as well as interest rate differentials. We
first estimate a version of these regressions by pooling data for all EMs in our
sample. We find strong support for the prediction that a measure of domestic
credit constraints is tightly linked with the real exchange in these countries.
Our model also predicts that the strength of the association between the
UIP premium and the local credit spread is governed by a parameter, γ ,
that measures the extent of frictions in the international credit market facing
borrowers in a given country. Next, we exploit the panel dimension of
our data set to test this prediction. While the value of γ is not directly
observable, the model suggests it should be positively linked to a country’s
overall macroeconomic vulnerability. Accordingly, we use the vulnerability
index constructed by Ahmed, Coulibaly, and Zlate (2017) as an indirect proxy
of γ . Ahmed, Coulibaly, and Zlate (2017) show that the value of this indicator
before the onset of global financial stress periods is a very good predictor
of subsequent pullback by international investors, thereby confirming that the
indicator is a good proxy for γ .
We first split our sample based on the value of the vulnerability index, and
estimate the exchange rate equations separately for each group. We find that
countries with weaker fundamentals (proxying for higher γ ) see a much tighter
association between the UIP premium and the domestic credit premium, as
predicted by the model. We then complement the split-sample approach by
estimating the empirical UIP specification country by country. We show that
the estimated coefficient for the domestic credit premium for each country lines
up cross-sectionally with the country’s respective vulnerability measure, in line
with the predictions of our model.
In our final empirical analysis, we estimate a vector autoregression
(VAR) model similar to Christiano, Trabandt, and Walentin (2010), whose
approach has been widely used to assess the effects of U.S. mone-
tary shocks on the U.S. economy. We augment empirical analysis in
Christiano, Trabandt, and Walentin (2010) to include data for EMs. We show
that our model’s predictions on the spillover effects of a U.S. monetary policy
shock on EM activity are broadly in line with the VAR-implied ones, that also
demonstrate large effects. This is in contrast with the predictions of a standard
312
New Keynesian model without credit market frictions, in which the effect on
EM output is fairly small under realistic parameterizations.
Our paper builds on a large literature that develops open-economy
New Keynesian macroeconomic models (e.g., Corsetti and Pesenti
2001; Gali and Monacelli 2005; Erceg, Gust, and Lopez-Salido 2007;
Farhi and Werning 2014; Corsetti, Dedola, and Leduc 2018). This literature
is based on the seminal work by Obstfeld and Rogoff (1995), who study the
effects of monetary and fiscal policies in open economies. The models in this

literature generally feature frictionless domestic and international financial
markets,4 while we depart by introducing financial market frictions following
Gertler and Kiyotaki (2010).5
This paper also relates to a lengthy literature that was developed in
response to the EM crises of the 1990s, which in several cases highlighted
the balance-sheet channel of exchange rate fluctuations. Well-known exam-
ples include Krugman (1999), Céspedes, Chang, and Velasco (2004), and
Gertler, Gilchrist, and Natalucci (2007).6 Our model also features balance-
sheet effects of exchange rates but is otherwise quite different from the models
in this literature. In our setting financial imperfections are microfounded via
an explicit agency problem, with the share of assets financed by each type of
debt determined endogenously as the solution to an optimal portfolio problem.
This setup leads to the interaction between domestic and external feedback
effects described earlier, a finding that we believe is novel, and implies greater
financial amplification than in existing models. Also different from the existing
literature, our paper focuses on quantifying the cross-border effects of U.S.
monetary policy.
Also related to our work is a set of papers that focuses on the role of financial
market imperfections in exchange rate determination (e.g., Hau and Rey 2006;
Bruno and Shin 2015b; Gabaix and Maggiori 2015; Itskhoki and Mukhin
2021). Different from the setup in these papers, in our setup EM intermediaries
seek funding in different currencies to fund a local productive asset, and
imperfect arbitrage arises because enforcement frictions have greater severity
for funds of foreign origin. This leads to the distinct prediction that the currency
premium is tied to the local lending spread, which we find has strong support in
the data, and which underpins the strong financial amplification effects that are
ultimately responsible for the large spillover effects of U.S. monetary policy.
The focus of our paper is related to Gourinchas (2018), who quantifies the
different channels of spillovers from U.S. monetary shocks. The details of
both modeling frameworks are quite different however, with ours devoting
4 In particular, these models generally feature either no deviations or exogenous deviations from UIP.
5 See also Bernanke, Gertler, and Gilchrist (1999), Gertler and Karadi (2011), Gertler, Kiyotaki, and Queralto
(2012), Gourinchas, Philippon, and Vayanos (2016), and Akinci and Queralto (2022) for related frameworks.
6 Other prominent papers are Aghion, Bacchetta, and Banerjee (2001), Aghion, Bacchetta, and Banerjee (2004),
and Braggion, Christiano, and Roldos (2009).
313
attention to endogenizing both the EM’s local lending spread and the currency
premium. Aoki, Benigno, and Kiyotaki (2016) develop a small open economy
model with financing frictions to study monetary and financial policies in
EMs, which shares several similarities with our model. Our work differs both
in terms of focus—we study spillovers from U.S. monetary policy within
an asymmetric two-country model—and in terms of modeling features, for
example, we highlight the importance of allowing for dollar invoicing of
international trade in EMs. In addition, our paper emphasizes the critical

role of endogenous deviations from UIP in shaping dynamics; we study
this issue within a simplified setting that allows for some analytical results,
and also provide evidence supporting the model-implied UIP deviations.
These considerations also differentiate our work from other related papers,
including Banerjee, Devereux, and Lombardo (2016), who focus only on
domestic financial frictions in accounting for cross-border spillovers, and
Fornaro (2015) and Devereux, Young, and Yu (2019), who focus on capital
controls and exchange rate policy during sudden stops in the context of a small
open economy framework with an occasionally binding collateral constraint.7
1. A Two-Country Model with Imperfect Financial Markets

Time is discrete and runs to infinity: t = 0,1,2,.... There are two countries, a
small EM (home) and the United States (foreign). Financial intermediaries
finance the acquisition of EM physical capital with funds borrowed both
from home households and from U.S. households. Each type of financing is
denominated in the source country’s currency. Because of limited enforcement
friction, intermediaries may face limits in their ability to borrow. The friction
affects the two types of borrowing (domestic and foreign) asymmetrically:
enforcement problems are more severe for funds of foreign origin. This
asymmetry leads to a failure of UIP, as we will show. The four types of agents
in the home economy are households, bankers, firms, and the central bank.
We describe each of these agents in turn, and then briefly describe the foreign
economy.
1.1 Households
A continuum of identical households of measure N live in the home economy.
Each household has two types of members: workers and bankers, with
measures 1−f and f , respectively. Workers supply labor and return the wages
they earn to the household. Each banker manages a financial intermediary and
also transfers his or her earnings to the household. There is perfect consumption
insurance between the two types of household members.
7 The IMF’s integrated policy framework, released after our paper, consists of two separate small open economy
models (Adrian et al. 2020; Basu et al. 2020) that have some similarities with the model proposed in our research.
Different from these papers, our framework is a two-country quantitative model with a focus on the role of
endogenous UIP deviations in the spillovers from U.S. monetary policy.
314
The representative household chooses a consumption index Ct , labor supply

Lt , consumption of a domestically produced (CD,t ) and imported (MC,t ) bas-
ket, deposits with domestic financial intermediaries Dt (denominated in terms
of the consumption index), and holdings of a one period nominal risk-free bond,
Bt (in zero aggregate net supply).Its optimization problem consists in choos-
∞
ing a state-contingent sequence Ct+j ,Lt+j ,CD,t+j ,MC,t+j ,Dt+j ,Bt+j j =0 to
maximize expected discounted lifetime utility
⎡ ⎤

∞

Et ⎣ β j U Ct+j ,Lt+j ⎦ , (1)
j =0
where U (C,L) is the period utility function. The consumption index is a CES
aggregate of the domestically produced and imported baskets:
η
η−1 η−1 η−1
1 η 1 η
Ct = (1−ω) CD,t +ω MC,t
η η , (2)
where 1−ω > 1/2 is the home bias and η > 1 is the elasticity of substitution
between goods of domestic and foreign origin. The maximization of (1) is
subject to a sequence of budget constraints of the form
Pt Ct +Pt Dt +Bt ≤ Wt Lt +Pt Rt Dt−1 +Rtn Bt−1 +t (3)
for all t, with
1
1−η 1−η 1−η
Pt = (1−ω)PD,t +ωPM,t . (4)
Here, Pt is the consumer price index (CPI); PD,t and PM,t are the prices of the
domestically produced and imported basket, respectively; Wt is the nominal
wage; Rt is the (real) gross interest rate on deposits; Rtn is the nominal interest
rate; and t are profits from firms and bankers rebated to the household.
Letting UC,t ≡ ∂U (C t ,Lt )
∂Ct
and UL,t ≡ ∂U (C t ,Lt )
∂Lt
, the first-order conditions for
Dt ,Bt ,Lt ,CD,t , and MC,t associated with the problem above are, respectively:

UC,t+1
βEt Rt+1 = 1, (5)
UC,t

UC,t+1 Pt n
βEt Rt+1 = 1, (6)
UC,t Pt+1
Wt UL,t
=− , (7)
Pt UC,t

PD,t −η
CD,t = (1−ω) Ct , (8)
Pt

PM,t −η
MC,t = ω Ct . (9)
Pt
315
The baskets CD,t and MC,t are themselves CES composites of a continuum
of good varieties produced at home and abroad, respectively, each of measure

1 −1

−1
unity. Thus, CD,t = 0 CD,j,t dj , where CD,j,t is consumption of domestic
variety j ∈ [0,1]. The associated first-order condition yields a standard demand
curve for domestic variety j from the domestic household:

PD,j,t −
CD,j,t = CD,t , (10)

PD,t
where PD,j,t is the price set by domestic producer j , and where
1 1−
1
1−
PD,t = PD,j,t dj (11)
0
is the domestic price index (i.e., an index of prices of the goods produced
domestically).
An analogous set of conditions holds for the imported consumption good
basket MC,t , with the same parameter governing the elasticity of substitution
between individual varieties.
1.2 Bankers
Each banker in the household operates a financial intermediary. Bankers exit
randomly: any banker operating in period t continues into period t +1 with
exogenous probability σ . With the complementary probability, the banker exits,
rebates his or her earnings to the household, and begins a career as a worker.
At the same time, workers in the household become bankers with probability
f
(1−σ ) 1−f , so a measure (1−σ )f of new bankers enter each period and exactly
offset the number that have exited. Entrant bankers receive a small equity
endowment from the household so they can start operations.
Banker i chooses assets Ai,t , deposits issued to domestic households in the
∗ 8
local currency Di,t , and deposits issued to U.S. households in dollars, Di,t .
∗
(Throughout, we use to refer to foreign variables.) The assets Ai,t consist of
claims on the EM’s physical capital. Theoptimization problem facing banker i ∞
∗
is to choose a state-contingent sequence Ai,t+j ,Di,t+j ,Di,t+j to maximize
j =0
⎡ ⎤
∞

Vi,t = Et ⎣ t,t+j (1−σ )σ
j −1
Ni,t+j ⎦
j =1

= Et t,t+1 (1−σ )Ni,t+1 +σ Vi,t+1 , (12)
8 Because any banker i is just one in a continuum, the domestic deposits are supplied with probability one by a
household different than the one banker i is a member of.
316
where
t,t+j ≡ β j UC,t+j /UC,t (13)
is the household’s stochastic discount factor (SDF) between period t and
period t +j , and Ni,t+j is terminal net worth if the banker exits at t +j . The
banker’s objective function is the expected value of its payout to the household,
evaluated using the household’s discount factor. (Note that the probability of
exiting in period t +j for a banker alive in period t is (1−σ )σ j .)

Maximization of (12) is subject to two constraints. The first is the banker’s
budget constraint, given by
Zt
Qt Ai,t +Rt Di,t−1 +Rt∗ St−1 Di,t−1
∗
≤ +(1−δ)Qt Ai,t−1 +Di,t +St−1 Di,t
∗
Pt
(14)
for each t. Here Qt is the (real) market price of a claim on a unit of capital;
Zt is the nominal payoff generated by a unit of asset holdings; δ is capital’s
depreciation rate; Rt∗ is the real interest rate in the foreign currency; and St is
the real exchange rate, expressed as the price of the home consumption index in
terms of the foreign index. Note that a real depreciation of the home currency
is captured by a decrease in St .
The balance sheet identity,
Qt Ai,t = Di,t +St−1 Di,t
∗
+Ni,t , (15)
states that the value of the banker’s assets equals the value of its liabilities
(consisting of the sum of the value of deposits issued in domestic and foreign
currency and the value of net worth, all expressed here in terms of the home
basket). This identity can be combined with (14) to yield
−1 ∗
Ni,t = (RK,t −Rt )Qt−1 Ai,t−1 + Rt −Rt∗ St−1 /St St−1 Di,t−1 +Rt Ni,t−1 , (16)
Zt
+(1−δ)Qt
where RK,t ≡ Pt Q is the return on bankers’ assets. Equation (16) can be
t−1
equivalently used in place of (14) as the banker’s balance sheet constraint.
The second constraint arises due to moral hazard. After borrowing funds,
the banker may decide to divert assets for personal gain, rather than honoring
obligations with creditors. Diverting means selling a fraction t ∈ (0,1) of
assets secretly in secondary markets. The remaining assets are then seized by
the banker’s creditors in bankruptcy proceedings. We assume that t depends
on the composition of the banker’s liability portfolio:

∗
St−1 Di,t
t= , (17)
Qt Ai,t
where (·) is a function satisfying > 0. Thus, the banker is able to divert
more assets when the fraction of his or her assets financed by foreign liabilities
∗
(equal to St−1 Di,t , once expressed in terms of the home basket) is larger.
317
The assumption that > 0 captures the notion that the legal and institutional
environment in EMs, as well as the nature of the EM capital which serves as
collateral, effectively make it more difficult for foreign creditors to recover
assets from a defaulting borrower, compared with domestic depositors.9
The banker’s decision then consists in comparing the continuation value
Vi,t , which measures the present discounted value of future payouts from
operating “honestly,” with the gain from diverting funds, t Qt Ai,t . Therefore,
the banker’s portfolio choice must also satisfy the incentive constraint

∗
St−1 Di,t
Vi,t ≥ Qt Ai,t , (18)
Qt Ai,t
which requires the banker’s continuation value to be no smaller than the value
of diverting funds. If (18) were not satisfied, no rational creditor would be
willing to lend to the banker, in recognition of the latter’s incentive to default.
This form of constraint, first introduced by Gertler and Kiyotaki (2010), has
been widely used in recent literature as a way to endogenize limits to bankers’
ability to attract funds. Our setting differs from the closed-economy variants
by allowing the degree of frictions to depend on the extent of foreign-currency
borrowing.
We now proceed to solving the banker’s problem using the method of
undetermined coefficients. We guess that the continuation value Vi,t satisfies
Vi,t = t Ni,t , where t is a time-varying coefficient that is independent of
banker-specific variables. We also define the following ratios:
Qt Ai,t
φi,t ≡ , (19)
Ni,t
∗
St−1 Di,t
xi,t ≡ . (20)
Qt Ai,t
The variable φi,t is the ratio of assets to net worth, the banker’s leverage. The
variable xi,t is the ratio of foreign financing to assets. Both ratios turn out to be
independent of banker-specific variables. In anticipation of that result we write
φi,t = φt and xt = xi,t .
From (16), the evolution of the banker’s net worth satisfies
Ni,t
= (RK,t −Rt )+ Rt −Rt∗ St−1 /St xt−1 φt−1 +Rt . (21)
Ni,t−1
Given this condition, along with (12) and (18), we may express the banker’s
problem as
t = max (μt +t xt )φt +νt (22)

xt ,φt
9 The Internet Appendix contains an additional discussion on this and on other model assumptions.
318
subject to
(xt )φt ≤ t = (μt +t xt )φt +νt , (23)
where

μt = Et t,t+1 Ωt+1 (RK,t+1 −Rt+1 )
, (24)
∗

t = Et t,t+1 Ωt+1 Rt+1 −Rt+1 St /St+1 ,

(25)

νt = Et t,t+1 Ωt+1 Rt+1 , (26)
with
Ωt+1 ≡ 1−σ +σ t+1 . (27)
The variable μt is the excess marginal value to the banker of assets over
deposits; t is the excess marginal cost of domestic relative to foreign funding
(equivalently, the marginal value of foreign relative to domestic funding); and
νt is the marginal cost of domestic funding. Note that the banker uses the
discount factor t,t+1 Ωt+1 to evaluate payoffs, which weighs the household’s
SDF with the prospective value of a unit of net worth to the banker (given
by Ωt+1 ). Condition (23) makes clear that the incentive constraint places a
restriction on the maximum leverage φt the banker can take on. The first-order
condition associated with the choice of xt is

(xt )
t = μt . (28)
(xt )− (xt )xt
This condition equates the marginal value of foreign relative to domestic

funding, t , to its marginal cost, which relates to the fact that a larger xt tightens
the incentive constraint (18).
As long as the total excess return μt +t xt satisfies
0 < μt +t xt < t,
the incentive constraint binds. We will assume this to always be the case. Then
from (23), the banker’s leverage φt is given by
νt
φt = . (29)
t −(μt +t xt )
We will restrict attention to cases in which xt can be solved for uniquely from
(28) as a function of μt and t (which are independent of any bank-specific
variables). Then, from (29) φt is also independent of bank-specific variables,
confirming our earlier statement.
319
f
We now turn to aggregation across bankers. Let At = 0 Ai,t di, Dt∗ =
f ∗ f
0 Di,t di, and Nt = 0 Ni,t di. Given that φt and xt are independent of bank-
specific factors, these aggregates satisfy
Qt At = φt Nt , (30)
St−1 Dt∗ = xt Qt At . (31)

If banker i is a new entrant, we assume he or she receives an equity
endowment Ni,t = f1 Wt , where Wt is a function of aggregate quantities to be
specified later. If banker i is instead a continuing banker, his or her net worth is
given by (21). Aggregating across all bankers yields the evolution of aggregate
net worth:
St−1 −1 ∗
Nt = σ (RK,t −Rt )Qt−1 At−1 + Rt −Rt∗ St−1 Dt−1 +Rt Nt−1 +(1−σ )Wt .
St
(32)
1.3 Firms
The two types of firms are capital goods producers that create new capital using
final goods and existing capital and final goods producers that employ labor and
capital to produce final output. We describe each in turn.
1.3.1 Capital goods producers We introduce capital producers to capture

convex costs of adjusting the capital stock in a way that facilitates aggregation.
This results in a “Tobin’s q” behavior of investment, with the rate of investment
increasing in the replacement cost of capital.
A domestic representative capital goods producer combines investment, It ,
and rented capital, Kt , to produce new capital. Investment is itself an aggregate
of domestic and foreign-produced goods. The capital goods producer’s activity
is subject to adjustment costs: producing It units of new capital requires It +
2
ψI
2
It
Kt
−δ Kt units of goods, where δ is capital’s depreciation rate. Thus,
adjusting the capital stock (beyond depreciation) entails quadratic costs.
The capital producer then sells new capital at the market price Qt . Its
maximization problem can be expressed as10
2
ψI It
max Qt It −It − −δ Kt . (33)
It 2 Kt
10 The capital goods producer also faces costs of renting capital, but these costs are of second-order around
the steady state (see Bernanke, Gertler, and Gilchrist 1999). Given that we restrict attention to the first-order
dynamics around the steady state, we can ignore the presence of the rental rate in (33).
320
The associated first-order condition is

It
Qt = 1+ψI −δ , (34)
Kt
which links the price of capital, Qt , positively to the investment-capital ratio.
The aggregate capital stock then evolves as
Kt+1 = It +(1−δ)Kt , (35)

with K0 given. New capital It is created using a mix of domestic (ID,t ) and
imported (MI,t ) goods, combined by means of an aggregator analogous to (2):
η
η−1 η−1 η−1
1 η 1 η
It = (1−ω) ID,t +ω MI,t
η η . (36)
From cost minimization, capital goods’ producers demand for domestic and
imported goods are

PD,t −η
ID,t = (1−ω) It , (37)
Pt

PM,t −η
MI,t = ω It . (38)
Pt
Like the case of consumption goods, ID,t and MI,t are themselves
CES composites of the domestic and foreign varieties, respectively: ID,t =

1 −1 −1
0 I
D,j,t dj , where ID,j,t is the amount of domestic variety j ∈ [0,1]
used in production of new capital goods. From cost minimization, the resultant
demand curve for variety j from capital producers is

PD,j,t −
ID,j,t = ID,t , (39)
PD,t
with PD,t given in (11). Similar conditions hold for the imported aggregate
MI,t .
1.3.2 Final goods producers A continuum of mass unity of differentiated

final goods producers sell in domestic and foreign markets and are subject to
pricing frictions. Let the j ∈ [0,1] subindex denote the producer of domestic
variety j . This producer employs capital, Kj,t , and labor, Lj,t inputs to produce
Yj,t units of variety j , by means of the production function
α
Yj,t = Kj,t L1−α
j,t . (40)
K
Cost minimization yields Wt
Zt
= (1−α) j,t
α Lj,t
for any j (Zt is the nominal rental rate
of capital), implying
Wt (1−α) Kt
= , (41)
Zt α Lt
321
1 1
with Kt = 0 Kj,t dj , Lt = 0 Lj,t dj . Cost minimization also yields the following
expression for (nominal) marginal cost, denoted as MCt :

Wt 1−α Zt α
MCt = . (42)
1−α α

1 −1 −1
Let Yt ≡ 0 Yj,t dj represent an index for domestic aggregate output.
For future reference, we note that up to a first order, the previous index relates

to aggregate employment and capital in a manner analogous to (40):11
Yt = Ktα L1−α
t . (43)
The pricing friction follows the Calvo formulation, whereby firm j is
randomly allowed to reset its price with probability 1−ξp . We assume that
firms in the domestic economy set prices in the local currency: they set the
price of goods sold in the domestic market in the domestic currency, and that
of goods sold in the foreign market in the foreign currency. (This contrasts with
producer currency pricing, in which prices are set in the producer’s currency,
regardless of the destination). We will assume that exporters in the foreign
country (the United States) set prices in dollars. Thus, our pricing assumptions
are consistent with the dominant currency paradigm (Gopinath et al. 2020),
in which export prices in any country are set in a “dominant” currency (the
dollar in our case). These assumptions are motivated by evidence suggesting
that a large fraction of international trade is invoiced in a small number of
dominant currencies, with the U.S. dollar playing an outsized role (see, e.g.,
Goldberg and Tille 2008; Gopinath et al. 2020).
Let P D,t denote the domestic price chosen by producer j if it can optimally
reset its price in period t. (This optimal price is the same for any j , so we omit
the j subindex). Producer j sets P D,t to maximize the present value of profits
generated while that price remains effective, subject to demand by domestic
consumers and capital goods producers (Equations (10) and (39), respectively).
The reset price P D,t satisfies the standard optimality condition
∞
P − P D,t MCt+k
D,t
Et k
(βξp ) UC,t+k (CD,t+k +ID,t+k ) − = 0.
k=0
PD,t+k Pt+k −1 Pt+k
(44)
Given that fraction ξp of producers set price P D,t , with the remaining producers
leaving their price unchanged, the domestic price index (11) satisfies
1−
1
1− 1−
PD,t = (1−ξp )P D,t +ξp PD,t−1 . (45)
11 To higher order, there exists a wedge between Y and K α L1−α that depends on the dispersion of prices among
t t t
producers, which arises due to the pricing friction.
322
∗
Turning to home’s export price, let P M,t be the price set by producer j in the
foreign market (denominated in the foreign currency, i.e., in dollars) in case
1
∗ 1 ∗1− 1−
the producer can reset its price in period t, and let PM,t = 0 PM,j,t dj
∗
denote home’s export price index. The price P M,t is chosen to maximize the
present value of profits generated from foreign sales. The resultant optimality
condition is
∞
P ∗ −

M,t ∗ ∗
Et k
(βξp ) UC,t+k ∗ (MC,t+k +MI,t+k )
k=0
P M,t+k
−1 ∗
Et+k P M,t MCt+k
− = 0, (46)
Pt+k −1 Pt+k
where Et is the nominal exchange rate (i.e., the price of the EM’s currency in
dollars). The evolution of home’s export price index is given by
∗1−
1
∗ ∗1− 1−
PM,t = (1−ξp )P M,t +ξp PM,t−1 . (47)
The fact that home producers set export prices in dollars implies a low
pass-through of exchange rate changes into home’s export prices. To see
this, suppose that prices are very rigid (ξp is close to one), and consider a
depreciation of the home currency against the dollar (a decrease in Et ). Under
our pricing assumption, the home’s export price index in dollars, given in (47),
will remain unchanged despite the lower Et . This stands in contrast to what
would occur under producer currency pricing, in which case the (dollar) export
∗pcp
price index would satisfy PM,t = PD,t Et . Thus, with a near-fixed PD,t , home’s
∗pcp
export price index PM,t would decline one-for-one with a depreciation of the
home currency.
The relation between the real exchange rate St , introduced earlier, and the
nominal exchange rate Et is
Et Pt
St = , (48)
Pt∗
whereby the real exchange rate equals the ratio of the home to foreign CPI.
1.4 Central bank

As a baseline, we assume the central bank in the EM sets the short-term nominal
n
rate Rt+1 according to the Taylor rule that targets only domestic inflation:

PD,t γπ
n
Rt+1 = β −1 εr,t . (49)
PD,t−1
We will later consider alternative policy rules. The rule (49) does not
include an output gap term. Our motivation for that assumption is the
323
evidence in Kaminsky, Reinhart, and Végh (2004) indicating that monetary

policy in emerging market economies generally does not feature strong
countercyclicality, unlike in advanced economies. We also allow for a domestic
monetary disturbance εr,t , which is assumed to follow an exogenous first-order
autoregressive process with persistence parameter ρm .
1.5 The foreign economy

The foreign country is analogous to home, with two differences: there are no

financial frictions, and exporting firms practice producer currency pricing. The
absence of financial frictions implies that the foreign household can be viewed
as directly holding physical capital. Foreign households can also deposit dollar
funds directly in EM banks, subject to the friction described above. Aside from
these differences, foreign agents’ decision problems are similar to those just
described, so for the sake of brevity we report here the resultant equilibrium
conditions.
A measure N ∗ of households live in the foreign economy. The foreign
household’s Euler equations for nominal dollar bonds, real dollar bonds
deposited in EM banks, and capital are the following:

∗
∗
UC,t+1 Pt∗
β Et ∗ ∗
n∗
Rt+1 = 1, (50)
UC,t Pt+1

∗
∗
UC,t+1 ∗
β Et ∗ Rt+1 = 1, (51)
UC,t
⎡ Z∗ ⎤
∗ t+1 ∗
U P ∗ +(1−δ)Qt+1
β ∗ Et ⎣ ∗ ⎦ = 1.
C,t+1 t+1
(52)
UC,t Q∗t
Optimization by U.S. household also requires a standard set of transversality

conditions. Labor supply satisfies
∗
Wt∗ UL,t
= − (53)
Pt∗ ∗
UC,t
The foreign household’s demands for foreign-produced and imported bundles
satisfy, respectively,
∗ −η
∗ ∗
PD,t
CD,t = (1−ω ) Ct∗ , (54)
Pt∗
∗ −η
∗
PM,t
MC,t = ω∗ Ct∗ . (55)
Pt∗
The foreign CPI is
1
∗1−η ∗1−η 1−η
Pt∗ = (1−ω∗ )PD,t +ω∗ PM,t . (56)
324
The conditions for investment, the evolution capital, and goods demand by
capital producers are
∗
It
Q∗t = 1+ψI −δ , (57)
Kt∗
Kt∗ = (1−δ)Kt−1 ∗ ∗
+It−1 , (58)
∗ −η
∗
PD,t
= (1−ω∗ ) It∗ ,

ID,t (59)
Pt∗
∗ −η
∗ ∗
PM,t
MI,t = ω It∗ . (60)
Pt∗
Foreign nominal marginal cost, the capital-labor ratio, and aggregate output
satisfy
Wt∗ (1−α) Kt∗
= , (61)
Zt∗ α L∗t
∗ 1−α ∗ α
Wt Zt
MCt∗ = , (62)
1−α α
α 1−α
Yt∗ = Kt∗ L∗t . (63)
Foreign firms set prices in the foreign currency and let the export price adjust
with changes in the value of the currency (i.e., satisfy the law of one price). The
∗
optimal reset price P D,t satisfies
∞ ∗
P ∗ − P D,t MCt+k ∗
∗ k ∗ D,t ∗ ∗
Et (β ξp ) UC,t+k ∗ (CD,t+k +ID,t+k ) ∗ − ∗ = 0,
k=0
PD,t+k Pt+k −1 Pt+k
(64)
and the producer price index obeys
∗1−
1
∗ ∗1− 1−
PD,t = (1−ξp )P D,t +ξp PD,t−1 . (65)
The law of one price for the foreign-produced basket implies

PM,t = Et−1 PD,t
∗
. (66)
Finally, the foreign central bank follows a Taylor rule that targets producer
inflation and deviations of output from its steady-state level Y ∗ , and includes
∗
a foreign monetary policy shock εr,t :
∗ γπ ∗ γy
PD,t Yt
n∗
Rt+1 = β ∗−1 ∗
∗
εr,t . (67)
PD,t−1 Y∗
∗
The shock εr,t follows an AR(1) with persistence ρm .
325
1.6 Market clearing and equilibrium

Market-clearing aggregate assets held by home bankers, At , implies that the
latter must equal the aggregate value of capital in period t (including period-t
investment):
At = It +(1−δ)Kt−1 = Kt+1 (68)
The home good’s market clearing condition is
N∗ ∗ ∗

Yt = CD,t +ID,t + MC,t +MI,t , (69)

N
whereby aggregate home output is either consumed domestically or exported.
∗
The term NN reflects the foreign population size is N ∗ , while the home
population size is N (note that all variables are expressed on a per-household
basis).
A similar market-clearing condition holds for foreign aggregate output:
N
Yt∗ = CD,t
∗ ∗
+ID,t + ∗ MC,t +MI,t (70)
N
Finally, the balance of payments, obtained by aggregating the budget
constraints of home households, bankers, and firms, is given by
PM,t PD,t N ∗ ∗
Dt∗ −Rt∗ Dt−1 ∗
= St (MC,t +MI,t )− (MC,t +MI,t ∗
) . (71)
Pt Pt N
This condition states that the EM’s net accumulation of foreign liabilities (the
left-hand side), expressed in terms of the foreign basket (i.e., in real dollars),
equals the value of the EM’s imports minus the value of its exports (the right-
hand side), also expressed in terms of the foreign basket (and adjusted by
relative population sizes).
An equilibrium consists of thirteen home aggregate quantities { Yt ,Ct ,
∗
t D,t ,MC,t ,At ,Dt ,Nt ,It ,Kt+1 ,In D,t ,MI,t
L ,C ,MCt }, nine home prices
Wt ,Zt ,Pt ,PD,t ,P D,t ,PM,t ,Qt ,Rt+1 ,Rt+1 , five banker coefficients
∗ ∗ ∗
{μt ,t ,νt ,xt ,φt }, 10 foreign quantities { Yt∗ ,Ct∗ ,L∗t ,CD,t ,MC,t ,It∗ ,Kt+1 ,
∗ ∗ ∗
∗ ∗ ∗ ∗ ∗ ∗ ∗
ID,t ,MI,t ,MCt }, nine foreign prices Wt ,Zt ,Pt ,PD,t ,PM,t ,P D,t ,P M,t ,

Q∗t ,Rt+1
n∗
, and the nominal and real exchange rates {Et ,St }, satisfying the 48
Equations (4)-(9), (24)-(32), (34)-(35), (37)-(38), and (41)-(71).
1.7 UIP premiums and credit spreads

There is a violation of UIP in this economy. In this section we highlight
its fundamental source. UIP fails because the agency friction limits interme-
diaries’ ability to arbitrage between riskless debt denominated in different
currencies. The model makes a stark prediction on the size of the UIP violation:
UIP premiums are larger whenever the domestic credit spread (the domestic
expected return on capital net of the risk-free rate) is elevated.
A number of simplifications of the model help convey the basic intuition.
Thus, for the remainder of the section we make use of the following
assumption.
326
Assumption 1. Households are risk neutral (UC,t = 1), bankers live for two
periods (σ = 0), and the function (x) is (x) = θ (1+γ x), with γ > 0, 0 < θ < 1.
Assumption 1 help isolate the basic force driving UIP premiums. The assumed
functional form for (x) implies a simple interpretation of the agency friction:
the parameter θ indexes the overall degree of contracting frictions, and γ
indexes the degree to which credit contracts with foreign households are more
difficult to enforce than contracts with domestic households. Equivalently, γ

measures inversely the quality of EM assets as collateral for foreign-currency
loans. To see this, suppose that banker i has a very small quantity of internal
resources (Ni,t → 0) and assume that he or she finances assets solely with
domestic funds (xi,t = 0). If the banker defaults, creditors are able to seize
(1−θ )Qt Ai,t . If instead the banker finances assets with foreign funds only
(xi,t = 1), creditors can only seize [1−θ (1+γ )]Qt Ai,t < (1−θ )Qt Ai,t .
We have the following result.
Proposition 1 (Violations of uncovered interest parity). Suppose Assumption
1 holds. Then the exchange rate, St , the domestic and foreign risk-free rates
∗
Rt+1 ,Rt+1 , and the domestic return on capital, RK,t+1 , satisfy
∗

Et Rt+1 −Rt+1 St /St+1 = γ Et RK,t+1 −Rt+1 > 0 (72)
Proof. From (13) and (27), UC,t = 1 and σ = 1 imply t,t+1 Ωt+1 = β. The result
then follows directly from Equation (28) given the assumed functional form for
(xt ).
The intuition underlying condition (72) is straightforward. Suppose the

intermediary marginally reduces its domestic borrowing, and marginally
increases its foreign borrowing. The benefit of this operation is given by the
left-hand side of (72) multiplied by β, which is the funding cost of domestic
loans minus the (expected ex post) cost of domestic loans. The cost of the
operation is that marginally raising xi,t tightens the leverage
constraint
by
γ , implying a foregone excess return of γ μt = γβEt RK,t+1 −Rt+1 . If the
banker’s portfolio is optimal in the first place, the benefit of the operation must
equal its cost.
Let z ≡ log(Z) for any variable Z, and assume that in steady state RK ≈ R ≈
R ∗ (i.e., steady-state differences between gross returns are small). Then to a
first order, Equation (72) is
∗
st = −γ Et rk,t+1 −rt+1 +rt+1 −rt+1 +Et [st+1 ], (73)
which can be solved forward to yield
∞ ∞

∗
st = −γ Et rk,t+j −rt+j +Et rt+j −rt+j + lim Et [st+j ]. (74)
j →∞
j =1 j =1
327
The real exchange rate depends positively on the expected sum of short-term
real interest rate differentials, as in standard macro models; but different from
them, as long as γ > 0 it also depends inversely on the infinite sum of expected
excess returns on capital (or credit spreads). The presence of this additional,
nonconventional term is an important feature of economic transmission in this
economy, as we illustrate in Section 2. In Section 3, we test condition (74) in
the data.12

1.8 Effects of reductions in intermediary net worth
Fluctuations in aggregate intermediary net worth Nt play a key role in shaping
model dynamics, and are key to the model’s implications for the cross-
border effects of U.S. monetary policy. In this section we make several
simplifying assumptions that yield a special case in which the dynamic effects
of exogenous shocks to net worth can be derived analytically up to a first-
order approximation. To be clear, in the complete model Nt is fully endogenous
(including to shifts in U.S. monetary policy), but considering an exogenous-N
economy yields useful insight into the model’s transmission mechanism.
To that end, we make the following additional simplifying assumption.
Assumption 2. Capital is the only production input (α = 1), adjusting it is

arbitrarily costly (φI → ∞), and there is no depreciation (δ = 0). The equity
endowment of entering bankers Wt satisfies
W t = w t Q t K0 , (75)
where wt is an exogenous variable with mean w ∈ (θ,1) satisfying log(wt /w) =

ρw log(wt−1 /w)+εw,t , 0 < ρw < 1, with εw,t denoting an iid disturbance.
Assumption 2 makes the model effectively an endowment economy, with the

capital stock fixed at its initial level: Kt = K0 for all t. Because σ = 1, aggregate
intermediary net worth is
Nt = Wt = wt Qt K0 . (76)
The EM’s aggregate financing need is Qt K0 , the value of the capital stock.
Because w < 1, in steady state bankers’ internal resources are insufficient to
finance the capital stock, so the economy requires financial intermediation. To
illustrate the aggregate consequences of lower intermediary net worth, we focus
in this section on the dynamic effects of a negative innovation in εw,t , which
makes the need for intermediation temporarily greater.
12 The last term in (74) satisfies lim

j →∞ Et st+j = s , given that the real exchange rate is stationary.
328
Under assumptions 1 and 2, combining expression (29) for the banker’s

leverage and the aggregate constraint (30) with Equation (76) yields
wt
1+γ xt = , (77)
(θ −μt )
where
St−1 Dt∗
xt = (78)
Q t K0

and
−1
Pt+1 +Qt+1
μt = βEt −1. (79)
Qt
From Equation (72), we have

β St
1−Et = γ μt . (80)
β ∗ St+1
The following result is useful in characterizing the system’s dynamics.
Lemma 1 (Dynamics of financial variables). Let β ∗ → 1, and assume that r ≡

β −1 −1 > 0 is “small” in the sense that it has the same order of magnitude
as fluctuations in aggregate variables. Then a first-order approximation of
Equations (77)-(80) yields
μ̃t = −θ ŵt +εx̂t , (81)
x̂t = d̂t∗ − ŝt − q̂t , (82)
q̂t = −μ̃t +Et [q̂t+1 ], (83)
ŝt = −γ μ̃t +Et [ŝt+1 ], (84)
where μ̃t ≡ (μt −μ), ŵt ≡ log(wt /w), x̂t ≡ log(xt /x), q̂t ≡ log(Qt /Q), ŝt ≡
log(St /S), and the parameter composite ε ≡ θ(w−θ)
w
.
Proof. In Internet Appendix.

∞
SolvingEquations
∞ (83) and (84) forward yields q̂t = −Et i=0 μ̃t and ŝt =
−γ Et i=0 μ̃t = γ q̂t : fluctuations in the price of capital and in the exchange
rate are both inversely linked to the path of the premium μ̃t . In turn, the latter
is linked inversely to net worth ŵt (for a given x̂t ), as made clear by (81).
The four equations (81)-(84) include the five variables μ̃t , x̂t , q̂t , ŝt , and d̂t∗ .
The fifth equation needed to tie down the system is the balance of payments
(71). The following Lemma derives the first-order dynamics of that equation
under some simplifying assumptions.
329
Lemma 2 (Evolution of balance of payments). Suppose assumptions 1 and 2

hold. In addition, let β ∗ → 1 as in Lemma 1, and suppose the countries have the
same size (N = N ∗ ), home and foreign households have symmetric preferences
with unit elasticity of substitution (ω = ω∗ ,η = 1), there are no pricing frictions
(ξp = 0) and no market power ( → ∞). Then a first-order approximation to the
balance of payments condition (71) yields
d̂t∗ = ŝt + d̂t−1
∗
, (85)

K0
where ≡ D ω
∗ (1−2ω)2 > 0.

∗
The system (81)-(85) has two state variables, one endogenous (d̂t−1 ) and one
exogenous (ŵt ). The following Proposition provides an analytical solution to
the dynamical system.
Proposition 2 (Dynamic effects of shifts in bank capital). Suppose = 1 and

γ < 3. The solution of system (81)-(85) satisfies
∗
ŝt = w ŵt − d d̂t−1 , (86)
d̂t∗ = w ŵt +(1−

∗
d )d̂t−1 , (87)
γθ √
d = 2 ε + ε(ε +4γ ) ∈ (0,1).
1
where w= √ > 0 and
1−ρw + 12 [ ε(ε+4γ )−ε]

With knowledge of ŝt , we can determine q̂t = γ −1 ŝt . Equations (82) and (81)
then can be used to recover x̂t and μ̃t , thus determining the full system.
To gain intuition, consider first a simple case in which the parameter
composite ε 0 (which occurs when w is close to θ ). From (81) this means
that the effect on the foreign funding ratio, x̂t , on the premium μ̃t is negligible.
γθ
The coefficients in (87) and (86) simplify to w 1−ρ w
and d 0. A decrease
γθ
in ŵt lowers the exchange rate ŝt with elasticity 1−ρ w
on impact, and lowers
θ
the price of capital q̂t with elasticity 1−ρw . This occurs because lower net
worth must be matched by a higher domestic premium, due to bankers’ binding
incentive constraint. This is accommodated by a lower price of capital today.
In turn, a higher domestic premium is associated with a larger UIP premium
on the local currency, triggering a depreciation. The stock of dollar debt d̂t∗
declines permanently.
When ε > 0, a second effect kicks in. Now, everything else equal, lower
d̂t∗ implies a lower premium μ̃t : a reduced stock of foreign funds eases the
∗
financing friction. (This effect explains why d̂t−1 enters (86) with a negative
330
sign). Because of this effect, in the wake of a currency depreciation and the
associated lower d̂t , a second force, that grows over time, exerts some upward
pressure on the currency. This makes d̂t mean-revert instead of experiencing a
permanent drop.13
Overall, despite its minimal nature due to the stark simplifications made in
this section, our model’s predictions on the effects of a decrease in net worth are
well-aligned with the phenomena observed in open economies experiencing
financial stress. Thus, in the wake of a negative shift in intermediaries’ net

worth, the model endogenously generates an increase in the domestic credit
premium, a drop in domestic asset prices, a wider UIP premium on the domestic
currency vis-á-vis the dollar, a depreciation of the local currency, and an
outflow of dollar funding.
2. Quantitative Analysis
We now turn to a quantitative analysis of the model. We focus on the model’s
predictions of the effects of U.S. monetary policy shocks, εr,t , on the EM.
We now drop the simplifying assumptions made in Sections 1.7 and 1.8,
and instead study a calibrated version of the complete model as laid out in
Sections 1.1 through 1.6.
2.1 Functional forms and parameter values

We assume the following functional forms for the period utility function U and
for the enforcement friction :
L1+χ
U (C,L) = log(C)− , (88)
1+χ
γ
(x) = θ 1+ x 2 . (89)
2
U (C,L) is a standard utility function. The function (x) has features similar
to the linear case studied earlier, but has the advantage of implying an interior
solution for the portfolio variable x. In steady state, the ratio x is positively
related to the difference between discount factors β and β ∗ and inversely related
to the parameter γ . This allows us to use data on foreign-currency-denominated
debt shares in EMs as a way to discipline the parameter γ .
The U.S. openness parameter, ω∗ , is assumed to be arbitrarily small: ω∗ → 0.
We also assume that the U.S. is arbitrarily large relative to the EM, N ∗ /N →
∞, and we let ω∗ N ∗ /N → ω, implying that trade is balanced in a steady state
with unit relative prices. The rationale for these assumptions is that an EM
13 This type of effect of the stock of foreign debt on the currency value is typical of models in which assets are
imperfect substitutes (Kouri 1976). For example, in Blanchard, Giavazzi, and Sa (2005) a similar effect arises
due to home bias in asset preferences. Different from these papers, in our model the imperfect substitutability
arises due to different degrees in financial frictions across different types of liabilities.
331
Table 1
Parameter values
Parameter Value
Household preferences
Discount factor β 0.9925
Discount factor (foreign) β∗ 0.9950
Frisch elasticity of labor supply χ −1 0.5
Preference weight on foreign goods ω 0.3
Substitution elasticity home/foreign goods η 1
Production

Prob. of keeping price fixed ξp 0.85
Net price markup θp 0.125
Capital share α 0.33
Capital depreciation rate δ 0.025
Elasticity of Qt to It /Kt φI δ 0.25
Monetary policy rule

Response to inflation γπ 1.5
Response to output gap (foreign) γy∗ 0.5/4
Monetary shock persistence ρm 0.5
Financial intermediaries
Survival rate σ 0.95
Fraction divertable θ 0.41
Home bias in bank funding γ 2.58
Transfer rate to new entrants ξb 0.067
is very small in size relative to the United States, and which therefore has
negligible weight in U.S. consumption and investment baskets. As we will see,
this implies that there are no “spillbacks” from the EM onto the U.S. economy.
Put differently, the U.S. behaves effectively like a closed economy. This makes
the model analysis simpler and more transparent.
Table 1 shows the remaining parameter values. We set the U.S. dis-
count factor β ∗ to 0.9950, implying a steady-state real interest rate of
2% per year. This choice is consistent with several recent studies (e.g.,
Reifschneider 2016) and is motivated by estimates of the U.S. natural rate (e.g.,
Holston, Laubach, and Williams 2017). To calibrate the EM’s discount factor,
we rely on estimates of Mexico’s long-run natural rate from Carrillo et al.
(2017) of about 3%, and accordingly calibrate β to 0.9925.14 The preference
and production parameters χ ,ω,η,ξp ,θp ,α,δ are set to conventional values.
The elasticty of Tobin’s q to the investment-capital ratio is set to 0.25, following
Bernanke, Gertler, and Gilchrist (1999). The Taylor rule parameters γπ ,γy are
set to standard values. The monetary shock’s autoregressive parameter ρm
is 0.5, as in textbook analyses (e.g., Gali 2015), consistent with a moderate
amount of persistence.
Turning to the parameters related to the financial market friction, we set the
survival rate σb to 0.95, implying an expected horizon of bankers of 6 years.
14 Magud and Tsounta (2012) also estimate the natural rate for several Latin American countries using various
methodologies. Averaging across methodologies yields a range of values between 2% and 5% across countries,
with a cross-country average of about 3%.
332
This value is around the midpoint of the range found in related work.15 We
set the remaining three parameters to hit three steady-state targets: a credit
spread of 200 basis points, a leverage ratio of 5, and a ratio of foreign-currency
debt to domestic debt (D ∗ /SD) of 30%. The target for the credit spread
reflects the average value of 5-year BBB corporate bond spreads in major
Asian and Latin American emerging market economies over the period 1999–
2017 (excluding the global financial crisis period). The target leverage ratio
is a rough average across different sectors. Leverage ratios in the banking

sector are typically greater than five,16 but the nonfinancial corporate sector
generally has lower asset-equity ratios (between two and three in emerging
markets).17 Our target of five reflects a compromise between these two values.
Finally, evidence in Hahm, Shin, and Shin (2013) on ratios of foreign-currency
deposits to domestic deposits in EMs suggests an average of about 30%. This
value is also consistent with evidence presented in Chui, Kuruc, and Turner
(2016), showing that average private-sector foreign currency debt across EMs
(for the period 2006-2014) as a percent of total (i.e. domestic- plus foreign-
currency denominated) debt is a little over 20%. These targets imply θ =
0.41,ξb = 0.067, and γ = 2.58. The implied value for the steady-state ratio of
foreign liabilities to assets is x = 0.18 (note that x follows from our targets for
φ and D ∗ /SD, via the balance sheet identity (15)).
2.2 Cross-border spillovers of monetary policy

∗
Figure 1 shows the effects of an unanticipated increase in εr,t of 25 basis points.
This shock would imply, in the absence of any endogenous response of U.S.
inflation or the output gap, an increase of 100 basis points in the annualized
U.S. nominal interest rate. The figure shows the effects in our baseline model
with financial market frictions (blue line with circles) and also includes the
effects in a “standard New Keynesian” model: an economy with complete
financial markets and producer currency pricing (i.e., a two-country version
of Gali and Monacelli 2016, augmented with endogenous investment).
Our baseline model predicts large effects on EM GDP of the U.S. monetary
disturbance. Aggregate activity in the EM falls by 0.25% on impact, a decline
of about two-thirds as a large as the drop in U.S. GDP itself. One quarter after
the shock, the reductions in EM and in U.S. GDP are roughly the same size.
An important reason for the sizable effect on EM GDP is a sharp reduction in
investment spending, which falls by nearly 1.5%, which is even more than in
15 For example, Gertler, Kiyotaki, and Prestipino (2020b) calibrate a survival rate of 0.93 and
Gertler, Kiyotaki, and Prestipino (2020a) of 0.935, while earlier work (Gertler and Kiyotaki 2010;
Gertler and Karadi 2011; Gertler, Kiyotaki, and Queralto 2012) reported values closer to 0.97.
16 For example, bank assets to capital averaged around 10 for Mexico in recent years. Source: IMF Global Financial
Stability Report.
17 See, for example, the IMF’s (2015) Global Financial Stability Report from the month of October (chap. 3).
333
0
0.06 0.06
-0.5
0.04 0.04
-1
-1.5 0.02 0.02
-2 0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0
0 0
-0.1
-0.5 -0.1
-0.2

-1 -0.2
-0.3
-1.5 -0.3
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0 0.25
0
0.2
-0.1
-0.5 0.15
-0.2
0.1
-1 -0.3
0.05
-0.4
-1.5 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0.25
0.2
0.15
0.1
0.05
0
0 2 4 6 8 10 12
Figure 1
U.S. monetary policy shock
∗ in (67) of 0.25%. The blue line with circles represents the effect
Effects of a rise in the U.S. monetary shock εr,t
in our baseline model, and the green line with crosses represents the effects in the standard New Keynesian
model.
the United States, and about six times as much in the standard New Keynesian
model.
The presence of strong feedback effects due to the financial market
friction is key to the large decline in EM investment following the U.S.
rate hike. Two types of feedback effects are at work. On the one hand, the
standard “financial accelerator” (Bernanke, Gertler, and Gilchrist 1999, BGG
henceforth) is present: lower intermediary net worth weakens investment
spending and Tobin’s q, which work to depress net worth further. What
our model adds is a “second-round” feedback effect operating through the
exchange rate and intermediaries’ dollar-denominated debt. As shown in
Section 1.8, lower intermediary net worth is associated with a wider UIP
premium and, accordingly, with a depreciated exchange rate. Given a lower
exchange rate, the dollar-denominated debt in banks’ balance sheets constitutes
a greater burden, which affects net worth negatively and starts another round of
feedback. Put differently, in our model there is feedback between Nt and Qt ,
for a given St (as in BGG); but there is also feedback between Nt and St , for
a given Qt . In general equilibrium, fluctuations in all three variables influence
and reinforce each other. These three-way feedback effects between Nt , Qt ,
334
and St are responsible for the roughly six-fold amplification of the investment
decline compared to a case in which the credit frictions are absent.
The presence of intermediary frictions also adds persistence to real variables:
investment in the EM recovers more slowly than it does in the United States,
and more slowly than the shock itself (which has persistence ρm = 0.5). The
reason is that rebuilding net worth takes time, as seen in the first panel. The
response of investment inherits the sluggishness in the recovery of net worth.
Finally, our model also implies a sizable real exchange rate depreciation in the

wake of the shock—twice as large as in the standard NK model—once again
driven by the powerful feedback effects between net worth and the exchange
rate.
In stark contrast, the effects on EM activity of the U.S. monetary shock in the
standard New Keynesian model are overall quite modest. An important reason
behind this result is the presence of expenditure-reducing and expenditure-
switching effects that affect EM activity in opposite directions. On the one
hand, lower U.S. aggregate demand is associated with lower demand for EM
goods, working to depress EM GDP. On the other hand, the EM’s exchange rate
depreciates when the U.S. tightens, making EM goods cheaper and leading
households and firms in both countries to switch expenditure toward EM-
produced goods, boosting EM GDP. The net result is a very modest decline
in EM activity. In addition the standard NK model cannot, by construction,
generate any effects of U.S. monetary policy on local credit spreads or UIP
premiums.18
Our model departs from the above in two main ways. First, the financial
constraints-driven three-way feedback effects work to greatly enhance the
effect on domestic absorption, via amplified fluctuations in investment
spending. Second, the presence of dominant currency pricing dampens
expenditure-switching effects. These two channels together imply a sizable hit
to EM activity from a tightening of U.S. monetary policy, consistent with much
evidence.
To clarify the role of intermediary balance sheets, in Figure 2 we report the
effects of a one-time redistribution of wealth between bankers and households,
sized to induce the same effect on net worth as in the previous experiment.19
This shock has no effects on the standard NK model, as it is just a redistribution
of resources within the representative household. With capital market frictions,
18 The finding that spillovers are small in the NK model raises the question of whether there exists a
parameterization of that model under which spillovers are large. We consider this question in the Internet
Appendix, and find that spillovers remain modest for a wide range of parameter values.
19 Specifically, we assume that all bankers operating in period t face a one-time transfer of 100ε
n,t percentage of
their pretransfer net worth, where εn,t is an exogenous iid shock. Accordingly, the evolution of aggregate net
worth is

S −1 ∗
Nt = eεn,t σ (RK,t −Rt )Qt−1 At−1 + Rt −Rt∗ t−1 St−1 Dt−1 +Rt Nt−1 +(1−σ )Wt .
St
335
0 0.06 0.03
-0.5
0.04 0.02
-1
0.02 0.01
-1.5
-2 0
0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0
0
0
-0.5 -0.05
-0.1 -0.05

-1
-0.15
-0.1
-1.5 -0.2
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0 0
0
-0.05
-0.1 -0.1 -0.2
-0.15
-0.2 -0.4
-0.2
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Figure 2
Shock to bankers’ net worth
Effects of a negative shock to bankers’ net worth.
in contrast, lower net worth feeds into higher credit and UIP premiums,
lower asset prices, and a depreciated home exchange rate, all of which are
qualitatively illustrated in the simplified setting of Section 1.8. There are two
key differences between that simpler setting and the complete model studied
here. First, given that bankers are long-lived, the evolution of net worth is
now endogenous. This opens the door to the feedback effects explained above,
whereby aggregate net worth affects the price of capital and the exchange rate,
but is also affected by them. Second, with endogenous production the decline
in Tobin’s q triggers lower investment demand and, given nominal rigidities,
lower aggregate GDP.
While an analysis of optimal monetary policy is beyond the scope of this
paper, the previous discussion offers some insights into how the credit frictions
complicate the task of the EM central bank. Avoiding the kind of financial
tightening effects shown in Figure 2 would require stabilizing intermediaries’
net worth Nt . But this is likely not possible with just one policy instrument
(the nominal rate Rtn ), because Nt depends on both the domestic asset price
∗
(Qt ) and the exchange rate (St ), and moderating the effects of εr,t on these two
variables requires adjusting the nominal rate in opposite directions—that is,
leaning against the fall in Qt calls for lowering Rtn , but fighting the depreciation
calls for increasing it. Thus, it will likely not be feasible for the EM central bank
to completely insulate intermediaries’ net worth from U.S. monetary shocks.20
20 In the Internet Appendix we consider the effects of the U.S. monetary shock under four alternative monetary
policy rules in addition to the rule (49). Consistent with the preceding discussion, we find that while the specific
336
0
0.05
0.1
-1 0.04
0.03
-2
0.05 0.02
-3 0.01
-4 0
0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0 0.5 0.5
-0.1 0.4 0.4

-0.2
0.3 0.3
-0.3

0.2 0.2
-0.4
0.1 0.1
-0.5
0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0.4 0.4 0.4
0.2 0.2 0.2
0 0 0
-0.2 -0.2 -0.2

0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0.4 0.25
Baseline model
0.2
0.3
0.15 Standard New Keynesian model
0.2
0.1
0.1
0.05
0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12
Figure 3
Domestic monetary policy shock
Effects of a rise in the domestic monetary shock εr,t in (49) of 0.25%. The blue line with circles represents the
effect in our baseline model, and the green line with crosses represents the effects in the standard New Keynesian
model.
2.3 Domestic monetary policy and the UIP puzzle

Here, we turn to the implications of our mechanism for the transmission of
domestic monetary policy. We begin by considering a domestic monetary
policy shock and highlight how the effects of this shock differ in our model
compared to the standard NK setup.
Figure 3 reports the effects of a 25-basis-point rise in εr,t . Two observations
stand out. First, the exchange rate dynamics following the domestic rate hike
are very different from those predicted by the standard NK model. In particular,
the response of both the nominal and real exchange rates is muted relative to
the effect implied by the NK model. The reason is that tighter domestic policy,
by depressing domestic asset prices and slowing the economy, creates a drag
on intermediary balance sheets, as shown in the first panel. The associated rise
in the currency premium, which is greatest in the initial periods, is responsible
for the milder appreciation of the domestic currency upon impact. This same
magnitudes differ, all the rules are associated with financial tightening in the EM and with significant spillovers
onto real activity.
337
mechanism implies the absence of exchange rate overshooting in our model,

consistent with recent evidence, and different from the NK model.21
Second, the effects on activity of the domestic monetary contraction are
also larger in our setting with credit frictions: the ensuing output contraction
is uniformly larger. This occurs because the decline in net worth, and the
associated rise in the domestic credit spread, induce a grater slowdown
in investment spending, explaining an overall larger output downturn. We
highlight, however, that the degree of amplification of the foreign monetary

shock is much larger than that of the domestic shock: the output decline is
almost four times larger in the latter case, and only about a third larger in
the former. This finding is consistent with the conventional view EMs are
particularly vulnerable to external shocks.
The “dampening” of the exchange rate response to domestic monetary policy
due to the credit friction has two interesting corollaries. The first is that an
exchange rate management policy is difficult to maintain in the presence of
credit frictions. This is seen most clearly by considering an exchange rate peg.
Absent the credit friction, UIP holds. Therefore, maintaining a peg calls for
raising the domestic policy rate one-for-one with any increase in the foreign
rate. In contrast, with the credit friction, raising the domestic rate strains the
balance sheets of intermediaries, limiting their ability to arbitrage and thus
raising the UIP premium, with a resultant lower effect on the currency than
if the UIP premium remained constant. As a result, the domestic policy rate
needs to be adjusted more than one-for-one with the foreign rate if the central
bank wishes to keep the exchange rate constant.
We illustrate this result in Figure 4. The figure shows the effects of a U.S.
monetary shock under a nominal exchange rate peg, in the standard NK model
(green dash-dotted line) and in our model with credit frictions (blue circled
line). The NK model features an increase in the domestic nominal rate of the
same size as the foreign rate (about 25 basis points), inducing a modest output
contraction. In our baseline model, the upward adjustment in the domestic
nominal rate is much larger, and the output drop is accordingly more severe.
The second corollary is that our model can account for the uncovered interest
parity puzzle (Engel 2014). Consider the third row of Figure 3. In the NK
model, UIP holds, and so the nominal interest rate differential between the
EM and the U.S. following the rise in domestic rates exactly matches the
expected nominal depreciation of the EM currency. This is not the case in our
model: in the short run, the higher domestic nominal rate is now associated
with an expected appreciation—resulting from the fact that higher nominal
rates impair intermediary balance sheets, widening the UIP premium.
21 Schmitt-Grohé and Uribe (2018) estimate empirical models of exchange rates featuring both permanent and
transitory monetary shocks, and find no overshooting in the exchange rate in response to either type of shock.
338
0
0.4 0.2
0.3 0.15
-5
0.2 0.1
-10
0.1 0.05
0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0 0 0.1
-0.5 0.05
-5 -1 0
-1.5

-0.05
-10
-2
-0.1
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
0.2
1 1
0.5 0.5 0.1
0 0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12 0 2 4 6 8 10 12
Figure 4
U.S. monetary policy shock under an exchange rate peg
∗ (67) of 0.25% under a nominal exchange rate peg. The blue line
Effects of a rise in the U.S. monetary shock εr,t
with circles represents the effect in our baseline model, and the green line with crosses represents the effects in
the standard New Keynesian model.
Table 2
UIP regressions on model-simulated data
Baseline model
NK model σ =2 σ =4 σ = 10
σ∗ σ∗ σ∗
a 0 0 0 0
b 1 0.92 0.43 −0.06
To illustrate the ability of the model to account for the UIP puzzle, we follow
equation (6) in Engel (2014) and run the regression
et+1 −et = a +b(rtn −rtn∗ )+ut+1 (90)
on model-simulated data, with the two monetary disturbances (domestic and
foreign) as driving forces. Table 2 shows the results, for different ratios of the
standard deviation of domestic monetary shocks (σ ) to the standard deviation
of foreign monetary shocks (σ ∗ ). In the NK model, the coefficients are always
a = 0 and b = 1, as expected. In our model, as long as domestic monetary shocks
are large enough (i.e., more important than foreign ones), the coefficient b is
below unity, and is inversely linked with the relative shock size σ/σ ∗ .22 A large
σ/σ ∗ seems plausible for EMs, where the volatility of nominal short-term rates
is much higher than in the United States.
22 We need σ/σ ∗ to be large enough because U.S. monetary policy shocks also raise the UIP premium.
339
3. Evidence on UIP Regressions

Our theory has an important testable prediction: unlike conventional open
economy macroeconomic models, such as Gali and Monacelli (2005) and
subsequent literature, our model features endogenous deviations from UIP,
with the currency premium moving in tandem with the domestic credit spread.
In this section, we test this model prediction in the data by estimating versions
of the forward-looking exchange rate Equation (74), as often done in the
empirical literature on the determinants of exchange rates.23 We start with

examining the connection between the domestic credit spread and the real
exchange rate in a panel-data setting where we pool data from several emerging
economies. We find strong support for the mechanism proposed in our model.
Next, we explore the cross-country heterogeneity of our sample. We show that
the domestic credit spread is more strongly associated with the real exchange
rate in emerging economies that have more fragile domestic macroeconomic
conditions, consistent with the predictions of our model.
3.1 Empirical UIP regression equation diff

Starting from (74), we let xt ≡ Tj=1 Et rk,t+j −rt+j and rt ≡
T
∗
j =1 Et rt+j −rt+j , and taking first differences we can write
diff
st = xt +rt +t , (91)
where t ≡ Et [st+T +1 ]−Et−1 [st+T ], that is, the forecast as of this period of the
real exchange rate T +1 periods ahead minus the forecast as of the previous
period of the exchange rate T periods ahead. We assume that if T is large
enough, both forecasts are approximately equal, and therefore t ≈ 0.24
Equation (91) forms the basis for our UIP regression analysis. Our baseline
estimation uses monthly data from several emerging economies. The number
of countries included in the regressions is mostly governed by data availability,
as we explain in detail below. We measure st by the (log) bilateral real exchange
rate against the dollar, calculated by multiplying the nominal exchange rate by
the ratio of the local to the U.S. CPI.
To approximate xt , we use two different measures of spreads, defined as
the difference between the rate at which corporations in emerging economies
borrow and the rate on government bonds of the same maturity and the same
currency. The first measure is yields on local currency corporate bonds minus
yields on domestic government bonds of the same maturity. The resultant
23 See, for example, Engel and West (2004, 2005), Engel, Mark, and West (2007), Faust et al. (2007),
Clarida and Waldman (2008), and, more recently, Galí (2020). Our approach follows the Galí (2020)
approach most closely. In earlier versions we followed the approach based on Fama (1984) and also found
evidence linking UIP deviations with credit spreads, as we find here.
24 As we will show in Section 3.4, our main results remain unchanged if we assume that the real exchange rate is
stationary around a deterministic trend and estimate the empirical model in levels.
340
corporate borrowing spread is a widely used proxy for the “external finance
premium” (Bernanke, Gertler, and Gilchrist 1999) arising due to the presence
of financial market frictions.25 Thus, we measure xt as
T corp gov
xt = rt −rt , (92)
12
corp gov
where rt is the local currency corporate bond yield (in annual terms), rt
is the yield on long-term domestic government bonds, and T = 60 months.
The second measure we use to approximate xt is dollar-denominated

corporate bond spreads. This measure has greatest coverage in terms of
number of countries. Specifically, we measure xt by the spread between 5-
year dollar-denominated corporate bonds and U.S. Treasury bonds of the same
maturity.2627
diff
Finally, we construct rt as
diff T gov gov∗
rt = rt −rt , (93)
12
gov∗
where rt is the (real) long run U.S. government yield. In (93), real yields
are constructed by subtracting from nominal yields the expected inflation rate
in each month, calculated as the average inflation rate over the past year.28
These calculations make the simplifying assumption that the expected sum of
one-period yields differentials in (91) are well approximated by the T -month
maturity bond yields.29
The final panel regression equation we arrive at after incorporating all these
definitions is
j −1
diff
sj,t = α0 + αk ηk +βx xj,t +βr rj,t +βv VIXt +εj,t , (94)
k=1
where j denotes countries, t is months, and ηk denotes country fixed effects.
We also include changes in the VIX index to control for global risk aversion.30
25 For recent uses of this measure, see, for example, Christiano, Motto, and Rostagno (2014) or Gertler and Karadi
(2015).
26 While in our baseline model the return R
K,t is denominated in local currency, in the Internet Appendix we show
that a relation similar to (91) arises when local firms issue dollar-denominated bonds to domestic banks (with the
corporate spread calculated relative to the U.S. government bond yield), so long as the agency friction continues
to apply with greater severity to banks’ foreign borrowing.
27 We also use bank lending-borrowing spreads to approximate x (see Section 3.4).
t
28 Note that expected inflation terms cancel in (92) given that r corp and r gov are in the same currency, so we can
t t
calculate st simply by using the difference of nominal yields.
29 Thus, if the T -month maturity bonds include a term premium in addition to the expected path of short-term
yields, our assumption is that the term premium is part of the regression error term.
30 Note that we measure interest rate differentials in (94) with EM bond yields, which partly reflect sovereign default
risk (absent in the model). While this may in principle be a concern, in practice it is likely that fluctuations in
sovereign credit risk correlate with measures of the tightness of financial constraints—as in the model of Bocola
(2016), for instance, which includes both financial constraints and sovereign default risk—which in our case
should be captured by the presence of EM corporate bond spreads in (94). Still, allowing for sovereign default risk
(and its interaction with financial constraints and UIP premiums) would be a very interesting model extension,
which would allow exploring this issue further.
341
Table 3
Empirical exchange rate equation in first-differences, st baseline panel-data estimates
Dollar-denominated bonds Local-currency bonds
(1) (2) (3) (4) (5) (6)
−0.12∗∗∗ −0.08∗∗∗ −0.08∗∗∗ −0.26∗∗∗ −0.25∗∗∗ −0.19∗∗

diff
Interest diff., rt
(0.03) (0.02) (0.02) (0.07) (0.08) (0.06)
Spread, xt −0.57∗∗∗ −0.51∗∗∗ −1.01∗∗∗ −0.98∗∗∗

(0.05) (0.07) (0.19) (0.21)

VIX
100 −0.05 −0.15∗∗∗
(0.03) (0.03)
Obs. 2,931 2,931 2,931 759 759 759
Adj. R 2 .029 .243 .249 .038 .241 .292
Country FE yes yes yes yes yes yes
N. of countries 15 15 15 5 5 5
Driscoll and Kraay standard errors in parentheses.
∗ p < .05; ∗∗ p < .01; ∗∗∗ p < .001.
Dollar-denominated corporate bond spreads are defined as the difference between yields on 5-year dollar-
denominated corporate bonds and U.S. Treasury bonds of the same maturity; and local-currency corporate bond
spreads are the difference between yields on 5-year local-currency denominated corporate bonds and domestic
government bonds of the same maturity. Interest differential is the difference between the real yield on 5-year
domestic government bonds and the real U.S. government yield of the same maturity. VIX is the CBOE Volatility
Index, an index representing the market’s expectations for the S&P 500 volatility over the coming 30 days. See
the Internet Appendix for the list of emerging countries included in each regression and data sources.
3.2 UIP premium: Baseline panel regressions

We estimate (94) by pooling monthly data from several emerging economies.31
The panel is unbalanced, with most countries starting in the 2000s, and runs
until the second month of 2022. Comparing our theoretical and empirical UIP
equations, (74) and (94), one would expect βx = −γ < 0, βr = 1, and βv < 0.
Table 3 reports the panel regression results. Columns 1–3 display the
estimated coefficients when the credit premium is proxied for by credit spreads
on dollar-denominated corporate bonds. Columns 4–6 show the corresponding
results when the premium is measured using local-currency corporate bond
spreads. Note that we include country fixed effects in all the regressions, and
compute t-statistics using Driscoll and Kraay (1998) standard errors, the panel
data analog of Newey and West (1987) time-series standard errors.
Column 2 shows our baseline specification with both the interest differential
and the corporate bond spread. The coefficient of interest is βx , and a negative
value on this coefficient indicates a negative association between the EM’s
real exchange rate and credit premium, as predicted in our model. As shown
in column 2, the coefficient for the spread is negative, as expected, and is
highly statistically significant. Moreover, the presence of the spread improves
the equation fit considerably: R 2 rises from nearly zero to around 0.25.
31 More precisely, when we proxy x by local currency spreads, we include the following 5 countries in the
t
panel data: Korea, Mexico, Russia, Singapore, and South Africa. In the regressions where xt is measured
using dollar-denominated credit spreads, our analyses cover in total of 15 emerging economies including Brazil,
Chile, Colombia, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Russia, Singapore, South Africa,
Thailand, and Turkey.
342
Column 3 performs a robustness check by including the VIX. The spread

continues to be significant even when this variable is included. Column 4
reports the corresponding results for local-currency bonds. The finding that
the corporate spread is highly significant reemerges here, as does the fact that
the presence of the spread adds considerable explanatory power relative to a
regression with the interest differential only. The only meaningful difference
is that the magnitudes of βx for local-denominated bonds are larger in absolute
value than that of dollar-denominated bonds. The VIX has a negative sign,

as before, but is now significant. Nonetheless, the spread continues to be
significant.
3.3 UIP premium: Cross-country heterogeneity

Our theory implies the coefficient for the spread in the regression is γ , the
parameter governing the degree of frictions in cross-border borrowing. Thus,
the model implies that in countries with larger γ , one should observe a larger
(in absolute value) coefficient for the spread in the regression. In this section
we explore the panel dimension of our data set to test this prediction.
The value of γ , however, is not directly observable. As an indirect proxy,
we use the vulnerability index constructed by Ahmed, Coulibaly, and Zlate
(2017). This index is based on six macroeconomic variables reflecting the
overall strength of macroeconomic fundamentals. The reasons we choose to
rely on this index are as follows. First, our model implies that a larger γ
leads to greater vulnerability to external shocks, which should manifest itself
in worse macroeconomic fundamentals. Second, Ahmed, Coulibaly, and Zlate
(2017) show that the index does an excellent job at predicting which countries
suffered greater pullback from investors during periods of global stress (such as
the taper tantrum of 2013). As such, the index captures well how wary investors
feel about lending to a particular EM, consistent with the interpretation of our
parameter γ . Finally, our analysis requires an indicator that is consistent across
countries in the sample, a requirement that this index satisfies.32
We proceed as follows. We first group EMs in our sample as either
Vulnerable or Nonvulnerable EMs. We classify Vulnerable (Nonvulnerable)
EMs as those countries whose vulnerability index is higher (lower) than
the sample median.33 We then rerun the baseline empirical UIP regression,
Equation (94), separately for these two groups of countries.
Table 4 shows the estimation results for vulnerable and nonvulnerable EMs.
Our theory predicts that the coefficient βx should be larger in absolute value
32 While it is less directly related to our theory, in the Internet Appendix we also differentiate countries based on
whether they have implemented capital controls in the past. One might expect a higher γ for countries that have
imposed such controls at some point in the past, a prediction we find some support for.
33 Accordingly, the following seven countries are identified as Vulnerable EMs: Brazil, Colombia, India, Indonesia,
Mexico, South Africa and Turkey. Note that all these countries have appeared in the so-called “fragile-five” group
at some point in time since the taper tantrum of 2013 when this term was first used by global financial market
participants. Recent empirical literature (e.g., Iacoviello and Navarro 2018; Degasperi, Hong, and Ricco 2021)
has also focused on these group of countries as being particularly exposed to U.S. monetary policy spillovers.
343
Table 4
Empirical exchange rate equation in first-differences, st the role of country vulnerabilities
Vulnerable EMs Nonvulnerable EMs Advanced econ.
(1) (2) (3) (4) (5) (6) (7) (8) (9)
−0.15∗∗∗ −0.08∗∗ −0.08∗∗ −0.09∗∗ −0.08∗∗ −0.07∗∗ 0.18∗∗∗ 0.16∗∗∗ 0.16∗∗∗

diff
Int. diff., rt
(0.04) (0.02) (0.02) (0.03) (0.03) (0.03) (0.04) (0.03) (0.03)
Spread, xt −0.66∗∗∗ −0.65∗∗∗ −0.41∗∗∗ −0.33∗∗ −0.32∗ −0.35∗

(0.05) (0.05) (0.09) (0.12) (0.13) (0.14)

VIX
100 −0.02 −0.07∗ 0.01
(0.03) (0.03) (0.02)
Obs. 1,177 1,177 1,177 1,754 1,754 1,754 821 821 821
Adj. R 2 .037 .333 .333 .015 .126 .146 .031 .046 .046
Country FE yes yes yes yes yes yes yes yes yes
N. of countries 7 7 7 8 8 8 3 3 3
∗ p < .05; ∗∗ p < .01; ∗∗∗ p < .001.
Spread is measured as the difference between yields on 5-year dollar-denominated corporate bonds and U.S.
Treasury bonds of the same maturity. Interest differential is the difference between the real yield on 5-year
domestic government bonds and the real U.S. government yield of the same maturity. VIX is the CBOE Volatility
Index, an index representing the market’s expectations for the S&P 500 volatility over the coming 30 days.
Vulnerability index is taken from Ahmed, Coulibaly, and Zlate (2017). See the Internet Appendix for the list of
countries included in each regression and data sources.
for the Vulnerable EMs. Columns 1–3 display the estimated coefficients, βr ,
βx and βν , for the group of vulnerable emerging economies. Columns 4–6
show the corresponding results for countries in the nonvulnerable group. We
also estimate the baseline UIP regression for a group of advanced countries,
shown in columns 7–9, which should have an even lower γ than the less-
vulnerable EMs. The spread variable in all these regressions corresponds to the
dollar-denominated corporate bond spread. As before, we include country fixed
effects in all the regressions, and compute t-statistics using Driscoll and Kraay
(1998) standard errors.
Three key results are worth emphasizing from the table. First, the coefficient
of interest, βx , is negative for all three group of countries. But importantly, the
magnitude of the coefficient is largest in the vulnerable EMs (the estimated βx
is −0.65 in the vulnerable group versus -0.33 in the less-vulnerable group).
Second, the spread adds meaningful explanatory power only for the vulnerable
emerging economies: R 2 rises quite significantly in the vulnerable group,
from around zero to 30%, while in the nonvulnerable group the increase in
explanatory power is about a third as large. Last, but not least, the credit spread
plays a minor role in explaining the real exchange rate in advanced economies.
As shown in column 9, the coefficient βx is barely significant, and R 2 increases
only 1.5 percentage points from 3% to 4.5% when credit spreads are included
in the regressions (comparing columns 7 and 8). We take this finding as a
suggestive evidence that countries with weaker fundamentals (proxying for
higher γ ) see a much tighter association between the UIP premium and the
domestic credit premium, consistent with the model.
344

Figure 5
Estimated βx versus Vulnerability index: First-difference specification
The y-axis of the figure displays the estimated coefficient for the change of spread, βx , from the regression
Equation (91) estimated country by country for each country in our sample. Dollar-denominated corporate bond
spreads are used as a proxy for the domestic market frictions in these regressions. Emerging countries highlighted
with blue have their estimated βx coefficients statistically significant. The x-axis displays the corresponding
vulnerability ranking of the country taken from Ahmed, Coulibaly, and Zlate (2017). The dark-gray line displays
the fitted regression line for the relationship between the estimated coefficient value and the average vulnerability
ranking, which has a negative slope.
We complement these panel regression results by estimating the empirical

UIP specification in Equation (91) country by country. We then exploit the
cross-country heterogeneity by examining whether the coefficient βx lines up
cross-sectionally with the vulnerability measure.
Figure 5 presents our results. The y-axis in the figure shows the estimated
coefficient for the first-differenced credit spread, βx , for each country in our
sample. The estimated coefficients for all countries in our sample are negative,
as expected. Moreover, for the majority of countries the estimated coefficient
is statistically different than zero (as indicated by the blue color in the figure).
The x-axis displays the corresponding vulnerability ranking of the country,
as computed in Ahmed, Coulibaly, and Zlate (2017). The dark-gray solid line
represents the fitted regression for the relationship between the estimated
coefficient value and the average vulnerability ranking. This fitted-regression
line is negatively sloped, indicating that in more-vulnerable countries the
coefficient βx is more negative, consistent with the predictions of our theory.
Note that countries in the fragile-five group appear at the bottom-right of
the figure, as expected, supporting the prediction that the relation between
exchange rates and credit spreads is especially tight in these countries.34
34 We analyze the extent to which other country-level characteristics, such as per capita income and the degree of
institutional development in EMs, are driving differences identified by the Vulnerability Index, and present our
results in the Internet Appendix.
345
Table 5
Empirical exchange rate equation in levels, st
Dollar-denominated bonds Local-currency bonds
(1) (2) (3) (4) (5) (6)
diff
Interest diff., rt 0.01 0.00 0.00 0.01 −0.14 −0.11
(0.07) (0.07) (0.07) (0.13) (0.10) (0.09)
Spread, xt −0.43∗∗ −0.40∗ −1.75∗∗∗ −1.39∗∗∗

(0.16) (0.19) (0.26) (0.28)

VIX
100 −0.03 −0.43∗∗∗
(0.16) (0.11)
Obs. 2,946 2,946 2,946 764 764 764
Adj. R 2 .630 .639 .639 .353 .497 .536
Country FE yes yes yes yes yes yes
N. of countries 15 15 15 5 5 5
∗ p < .05; ∗∗ p < .01; ∗∗∗ p < .001.
Dollar-denominated corporate spreads are defined as the difference between yields on 5-year dollar-denominated
corporate bonds and U.S. Treasury bonds of the same maturity; and local-currency corporate spreads are the
difference between yields on 5-year local-currency denominated corporate bonds and domestic government
bonds of the same maturity. Interest differential is the difference between the real yield on 5-year domestic
government bonds and the real U.S. government yield of the same maturity. VIX is the CBOE Volatility Index,
an index representing the market’s expectations for the S&P 500 volatility over the coming 30 days. Quadratic
trend is used for all countries except for Chile, Malaysia, Singapore and Thailand for which a linear trend is
used. See the Internet Appendix for the list of countries included in each regression and data sources.
3.4 UIP premium: Robustness

This section runs two robustness checks of the baseline results presented in
Table 3. The first estimates the UIP regressions in levels instead of in first
differences. The second uses bank lending-deposit spreads data to proxy the
extent of domestic financial market imperfections, instead of corporate bond
spreads.35
Turning to our first robustness check, we start from (74), impose the
diff
definition of xt and rt as before, and assume that st = ft + st , where ft is a
deterministic time trend and st is the long-run real exchange rate. We assume
the real exchange rate is stationary around the trend, so that if T is large enough
Et {st+T +1 } ≈ 0.36 The equation then becomes
diff
st = −γ xt +rt +ft+T +1 . (95)
Table 5 shows our panel estimation results for the level specification.
Columns 1–3 display the estimated coefficients when domestic market frictions
35 We also checked whether our results remained unchanged when we augment our empirical specification to
include a measure of covered interest parity (CIP) deviations (see Valchev 2020, Avdjiev et al. 2019 and
Jiang, Krishnamurthy, and Lustig 2021, who establish a link between the convenience yield and the exchange
rate for advanced economies, and Du, Im, and Schreger 2018, who quantify the difference in the convenience
yields of U.S. Treasuries and government bonds of foreign countries by measuring the deviations from CIP). As
shown in the Internet Appendix, our baseline results remain unchanged.
36 We found strong support in the data for the assumption that real exchange rates are approximately back to trend,
in expectation, after T months (with T around 60 months) in most of the countries in our sample.
346
Table 6a
Empirical exchange rate equation in first-differences, st
Lending-deposit spread
(1) (2) (3)
diff
Interest diff.,rt −0.11 −0.09 −0.07
(0.06) (0.06) (0.06)
Spread, xt −0.46∗∗ −0.43∗

(0.17) (0.17)

VIX
100 −0.18∗∗∗
(0.03)
Obs. 3,842 3,842 3,842
Adj. R 2 .002 .027 .112
Country FE yes yes yes
N. of countries 13 13 13
are proxied for by credit spreads on dollar-denominated corporate bonds, and

columns 4–6 show the corresponding results when the degree of financial
frictions is measured using local-currency corporate bond spreads. We include
country fixed effects and a linear or quadratic trend for each country in
all the regressions. Focusing on columns 3 and 6, we see that our baseline
results remain unchanged: the coefficient for the spread xt remains negative,
as expected, and highly significant, especially for the regressions using local-
currency spreads.
The second robustness test is that we use bank lending spread data to proxy
for the tightness of domestic financial constraints. More specifically, we rerun
the regression shown in Equations (94) and (95) (i.e., the first difference and
the level specifications, respectively) using the bank lending-deposit spreads
to measure xt . One reason that the bank lending-deposit spreads also may
be a good proxy for the tightness of domestic financial market frictions is
that corporations in many of these economies quite heavily depend on direct
bank lending in addition to debt issuance to obtain financing. However, it
is important to note that an advantage of corporate bond spreads (a market-
determined measure) relative to bank lending rates is that bank loan contracts
likely contain nonprice terms that are difficult to quantify and that may also
capture the kind of impediments to external finance that the theory emphasizes
(an argument emphasized by Gertler and Lown 1999).
Our results for both the first-differences and the level specifications for the
real exchange rate regressions are shown in Tables 6a and 6b, respectively.
The main results remain robust to using the alternative measure of financial
markets imperfections, as the estimated coefficient for spread for both the first-
differences and the level specification remain negative and significant.
4. Effects of U.S. Monetary Shock: VAR versus Model

Our model’s predictions for the cross-border spillovers from a U.S. monetary
policy shock are consistent with those implied by VAR-based estimates. To
347
Table 6b
Empirical exchange rate equation in levels, st
Lending-deposit spread
(1) (2) (3)
diff
Interest diff.,rt 0.11 0.44 0.46
(0.27) (0.23) (0.23)
Spread, xt −1.82∗∗∗ −1.79∗∗∗

(0.21) (0.21)

VIX
100 −0.32∗
(0.14)
Obs. 3,855 3,855 3,855
Adj. R 2 .603 .632 .641
Country FE yes yes yes
N. of countries 13 13 13
∗ p < .05; ∗∗ p < .01; ∗∗∗ p < .001.
Spread is measured as the difference between the lending rate by domestic commercial banks to firms and the
deposit rate. Interest differential is the difference between the real yield on 3-month domestic Treasury bonds and
the real U.S. Treasury yield of the same maturity, consistent with the average maturity of lending and deposits
rates. VIX is the CBOE Volatility Index, an index representing the market’s expectations for the S&P 500
volatility over the coming 30 days. See the Internet Appendix for the list of emerging countries included in
each regression and data sources.
show this, we augment the VAR model of Christiano, Trabandt, and Walentin
(2010) to include quarterly aggregate GDP, investment, and the real exchange
rate from a set of emerging economies. We focus on EMs that are not on
fixed exchange rate regimes, consistent with our model.37 More specifically,
we start from the original specification of Christiano, Trabandt, and Walentin
(2010) that includes U.S. GDP, inflation, unemployment, capacity utilization,
consumption, investment, and the federal funds rate. We then estimate their
model after incorporating data for EM GDP, investment, and the exchange
rate for the period 1978:I–2008:IV. We use a Cholesky shock identification
which relies on ordering the federal funds in the next-to-last position, with the
last variable being the EM exchange rate. This ordering embeds the standard
assumption that the only real variable that the U.S. monetary policy shock
affects contemporaneously is the federal funds rate, while allowing the U.S.
monetary shock to affect the EM exchange rate contemporaneously.
37 We use the classification in Ilzetzki, Reinhart, and Rogoff (2019) to identify nonpeggers. We classify
as nonpeggers the countries with an average of three or higher in the “coarse” classification of
Ilzetzki, Reinhart, and Rogoff (2019). The resultant set of countries includes Brazil, Chile, Colombia, Israel,
Korea, Mexico, Peru, Philippines, Singapore, South Africa, and Turkey. We then aggregate individual country-
level series for GDP, investment, and the real bilateral exchange rate against the U.S. dollar, to construct EM
aggregates of these series. We focus on aggregated data to facilitate comparison with recent related empirical
work (e.g., Iacoviello and Navarro 2018), and because it allows for a longer time series given the unbalanced
nature of some of the individual country data. That said, we have also run our VAR on a country by country
basis (for those countries with long enough time series for all variables) and found that the VAR results with
the aggregated data do a good job of capturing the effect on the “average” EM. These results are available on
request. We restrict our sample to start from 1978 instead of 1951 as in Christiano, Trabandt, and Walentin (2010)
because reliable EM data start from the late 1970s.
348
Figure 6
Effects of 1% rise in federal funds rate, VAR versus model
EM output, EM investment, and EM real exchange rate refer to aggregates of output, investment and the bilateral
real exchange rate, respectively, from a set of emerging economies with floating exchange rates. The units are
given in the titles of the subplots. % means percent and p.p. means annualized percentage point, both expressed
in deviations from baseline path obtained in the absence of the shock.
Figure 6 compares the VAR-implied effects of a monetary shock that raises

the fed funds rate by 1 percentage point with those predicted by an extended
version of our model. The extended model augments the setup of Section 1 with
nominal wage stickiness, habit persistence in consumption, and adjustment
costs in trade flows, among other features. These features help produce
more empirically realistic dynamics, as the literature has widely emphasized
349
(e.g., Christiano, Eichenbaum, and Evans 2005).38 The dashed lines in the
figure represent the effects predicted by a “standard” DSGE model, which
includes the real frictions just mentioned, but assumes frictionless financial
markets and producer currency pricing.
Starting with the United States, the model captures the dynamic response
of U.S. output and investment very well. The shock induces output to fall
around 0.50% at the trough, very close in magnitude to the decline implied by
our model. U.S. GDP displays a slow and hump-shaped response to a shock,

peaking a little over one year after the monetary shock hits, which the model
also captures quite well. Lastly, while the VAR-implied effect of the monetary
shock on the fed funds rate is roughly gone after a year, the U.S. economy
continues to respond well after that. The model predicts that U.S. GDP remains
below its path absent the shock for about 3 years, consistent with the evidence,
even though the effect of the shock on the interest rate dies out after a year
and a half. The model-implied response of U.S. investment over the first two
to 3 years after the shock is closely aligned to the VAR-implied effects as well.
Overall, this suggests that our model’s internal propagation channels allow it
to capture the dynamic effects of a monetary policy shock.
Next, we compare our model’s predictions for the effects of a U.S. monetary
policy shock on the EM with the VAR-implied effects. The VAR implies an
effect on EM GDP at a horizon of 1 to 2 years that is comparable in size to the
effects on U.S. GDP itself (a decline of about 0.5%), a result that the model
replicates quite well. Thereafter, the VAR implies a large degree of persistence
in EM GDP, larger than in the model, though the confidence bands are quite
wide. Overall, the model replicates the VAR-implied response reasonably well,
with the model-predicted GDP path mostly inside the VAR-implied confidence
bands.
Turning to EM investment, here again we find support in the data for a key
channel in the model, working through investment spending. The magnitude
of the EM investment decline in the data is larger than the decline in U.S.
investment, consistent with our model. As with GDP though, there are some
differences in the dynamic pattern of the effects, with the model-implied
response more front-loaded than the VAR-implied one.
Finally, the large near-term response of the EM exchange rate implied by our
model also finds support in the data, with the magnitudes of the depreciation
in the first few quarters being broadly comparable between model and data.
Thereafter, however, the predictions differ: the model implies a relatively quick
return of the real exchange rate back to its no-shock path, while the VAR
responses feature a much more persistent decline.
Overall, we conclude that the model’s predictions on the spillover effects of a
U.S. monetary policy shock on EM activity, investment, and the exchange rate
38 The Internet Appendix contains a description of the extended model.
350
are broadly consistent with the VAR-implied ones (with the largest discrepancy
being the high persistence in the empirical real exchange rate response).
We highlight that this is not the case in the standard DSGE model, which
predicts effects on EM output, investment, and the exchange rate that are very
far from their empirical counterparts. We have also found that the model-
implied effects on the EM UIP premium of the U.S. monetary shock are
consistent with the estimates by Kalemli-Özcan (2019), who use estimates
from Kalemli-Özcan and Varela (2021) of UIP premiums, which rely on survey

data of exchange rate expectations. See the Internet Appendix for a comparison.
5. Conclusion
In this paper we develop a two-country New Keynesian model with imperfect
domestic and international financial markets to study the cross-border
spillovers from U.S. monetary policy. The model features strong financial
amplification due to the powerful interaction between internal and external
feedback effects. Consistent with the estimates we obtain from a VAR model,
this mechanism leads to large spillovers from U.S. monetary shocks to EMs.
We believe our model is better tailored than existing macroeconomic models to
some of the specific features of EMs, which are often seen as being particularly
vulnerable to volatile capital flows and other external pressures.
Despite strong amplification working in part through exchange rate
volatility, the model calls into question the common view that monetary policy
should be used to mitigate exchange rate fluctuations. The reason is that
the endogenous currency premium partly offsets the conventional effect of
a change in the domestic policy rate on the exchange rate. The resultant
“disconnect” between the exchange rate and the domestic policy rate implies
that much larger domestic macroeconomic volatility is necessary for a given
reduction in exchange rate instability.
Looking forward, it would be useful to employ a version of our model to
consider optimal policy and how it can be implemented in the context of interest
rate policy and foreign exchange market inventions on the part of EM central
banks. Given the endogenous deviation from UIP in the model, there may be a
role for interventions in foreign exchange over and above conventional interest
rate policy. This extension is left for future research.
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Exchange Rate Dynamics and Monetary Spillovers

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Exchange Rate Dynamics and Monetary Spillovers

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Exchange Rate Dynamics and Monetary

Spillovers with Imperfect Financial Markets

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We develop a quantitative model with imperfections in domestic and international financial

The Review of Financial Studies 37 (2024) 309–355

finding in this literature is that these spillovers can be substantial, particularly

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valuable as collateral against dollar loans than against domestic-currency loans.

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demand). Given the strength of these feedback mechanisms, the amount of

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1. A Two-Country Model with Imperfect Financial Markets

The representative household chooses a consumption index Ct , labor supply

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t = max (μt +t xt )φt +νt (22)

(xt )φt ≤ t = (μt +t xt )φt +νt , (23)

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Ωt+1 ≡ 1−σ +σ t+1 . (27)

This condition equates the marginal value of foreign relative to domestic

0 < μt +t xt < t,

St−1 Dt∗ = xt Qt At . (31)

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1.3.1 Capital goods producers We introduce capital producers to capture

The associated first-order condition is

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1.3.2 Final goods producers A continuum of mass unity of differentiated

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1.4 Central bank

evidence in Kaminsky, Reinhart, and Végh (2004) indicating that monetary

1.5 The foreign economy

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Optimization by U.S. household also requires a standard set of transversality

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The law of one price for the foreign-produced basket implies

1.6 Market clearing and equilibrium

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1.7 UIP premiums and credit spreads

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The intuition underlying condition (72) is straightforward. Suppose the

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Assumption 2. Capital is the only production input (α = 1), adjusting it is

where wt is an exogenous variable with mean w ∈ (θ,1) satisfying log(wt /w) =

Assumption 2 makes the model effectively an endowment economy, with the

12 The last term in (74) satisfies lim  

Under assumptions 1 and 2, combining expression (29) for the banker’s

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From Equation (72), we have

Lemma 1 (Dynamics of financial variables). Let β ∗ → 1, and assume that r ≡

μ̃t = −θ ŵt +εx̂t , (81)

x̂t = d̂t∗ − ŝt − q̂t , (82)

q̂t = −μ̃t +Et [q̂t+1 ], (83)

ŝt = −γ μ̃t +Et [ŝt+1 ], (84)

Proof. In Internet Appendix.

Lemma 2 (Evolution of balance of payments). Suppose assumptions 1 and 2

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Proof. In Internet Appendix.

Proposition 2 (Dynamic effects of shifts in bank capital). Suppose  = 1 and

d̂t∗ = w ŵt +(1−

t = max (μt +t xt )φt +νt (22)

(xt )φt ≤ t = (μt +t xt )φt +νt , (23)

0 < μt +t xt < t,

12 The last term in (74) satisfies lim

Proposition 2 (Dynamic effects of shifts in bank capital). Suppose = 1 and

3.1 Empirical UIP regression equation diff

Spread, xt −0.57∗∗∗ −0.51∗∗∗ −1.01∗∗∗ −0.98∗∗∗

Spread, xt −0.66∗∗∗ −0.65∗∗∗ −0.41∗∗∗ −0.33∗∗ −0.32∗ −0.35∗

Spread, xt −0.46∗∗ −0.43∗