We construct a two-country New Keynesian model in which US government debt has an advantage as a superior collateral asset in the balance sheets of banks. The model can account for the observed response of the US dollar and US bond returns to a global downturn, and in particular when the downturn arises from a shock to the global financial system. Our model predicts that the U.S. enjoys an “exorbitant privilege” as its government bonds are desired by banks both in the U.S. and abroad as superior collateral. In times of global stress, the dollar appreciates and the “convenience yield” earned by U.S. government bonds creases. There is “retrenchment” - each country reduces its holdings of foreign assets - a critical determinant of which is the endogenous response of prices and returns. In addition, the model displays a U.S. real exchange rate appreciation despite that domestic absorption in the US falls relative to the rest of the world during a global downturn, thus addressing the “reserve currency paradox” highlighted by Maggiori (2017).
