Vehicle Currencies, Bank Debt and the Asset Market Approach to Exchange Rate Determination: The US Dollar, 1980-1985

This paper examines the appreciation of the dollar over the period 1980-85. The standard theories try to explain the increased demand for dollar assets by differential rates of return on bonds or by "safe-haven" arguments associated with the lower riskiness of United States assets. Neither of these explanations has proved satisfactory, however, and this has led to the search for other theories, including non-rational theories such as speculative bubbles and chartism. This paper proposes an alternative explanation, based on the role of the dollar as a vehicle currency and, in particular, the dominance of interbank transactions. It is shown that, in the years when the dollar appreciated most, changes in banks' assets and liabilities dominated the United States capital account. These were also years when United States banks were locked into large long-term foreign dollar loans to developing countries which, to make matters worse, were highly risky and often required further loans to help service the debt. Since deposits are mainly short-term and loans are long-term, the short-run demand for dollars is inelastic. In our view a decrease in the supply of dollar deposits at various times was a major cause of the dollar's appreciation. A formal model of exchange rate determination, based on the portfolio behaviour of banks, is developed and the predictions are shown to be consistent with the available evidence.