This paper investigates the transmission mechanism of US (un)conventional monetary policy shocks to exchange rates through the lens of global investors’ portfolio rebalancing. The empirical findings show that a tightening US (un)conventional monetary surprise is associated with lower domestic asset prices, net portfolio inflows to the US, and appreciation of the dollar. To quantitatively examine this mechanism, we develop a two-country New Keynesian dynamic stochastic general equilibrium (DSGE) model with financially constrained banks and foreign exchange (FX) dealers. The main insight is that a tightening (un)conventional monetary shock raises the expected returns of domestic assets and induces portfolio inflows to home country as a result of global investors’ substitution towards domestic assets. FX dealers intermediate the associated imbalances subject to limited risk-bearing capacity, which leads to appreciation of the home currency. Our model explains several empirical puzzles on currency premia and bond term premia. We discipline our quantitative model by targeting estimates from a structural vector autoregression (SVAR). Our quantitative analysis indicates that FX dealers’ limited liquidity intermediation plays a crucial role for the effectiveness of QE in an open economy.

Keywords: Asymmetric effect, Banks, Exchange rates, Financial constraints, FX dealers, Global portfolio flows, Home bias, Risk premia, (Un)conventional monetary policy, ZLB