CENTRAL BANK SWAPS AND INTERNATIONAL DOLLAR ILLIQUIDITY

We derive an international centralized and decentralized market model, in the spirit of Lagos and Wright (2005), where agents can experience asset-specific illiquidity. We apply the analysis to the question of dollar illiquidity during the global financial crisis and the response through international swap arrangements conducted by the Federal Reserve during that crisis. Our results show that it is possible for a deterioration in US asset values, analogous to the meltdown experienced during the global financial crisis in US real estate and asset-backed securities, to actually result in an appreciation in the dollar exchange rate, as was observed at the crisis apex. The intuition behind this counterintuitive result is that the deterioration in other dollar asset values reduces the availability of dollars for transactions purposes. Given that dollars are required for some transactions, this raises the demand for other dollar assets, such as cash, that can substitute in providing these liquidity services. Our model predicts that the benefits of swap arrangements, such as those pursued by the Federal Reserve swap arrangements are likely to be dependent on a number of agent characteristics. The benefits are shown to be increasing in the probability of needing to transact in dollars, the opaqueness of an agent's asset portfolio, and its illiquidity.