Economists Unveil Model Showing How Fed Decisions Shift Global Risk Appetite and Jolt Markets

Two economists have developed a new framework to explain how decisions by the U.S. Federal Reserve can ripple through global markets by changing the risk appetite of key financial intermediaries.

In their general equilibrium model, Rohan Kekre and Moritz Lenel focus on a class of “arbitrageurs” who trade across countries and currencies to exploit small price differences. The central mechanism hinges on a common feature of global finance: many investors and intermediaries fund themselves in one currency while holding assets in another, creating currency mismatches on their balance sheets.

The authors assume these arbitrageurs choose portfolios that are mean-variance efficient—a standard finance benchmark that describes how investors allocate wealth to achieve the best tradeoff between expected return and risk. Under that condition, the model implies a striking portfolio feature: arbitrageurs end up effectively short the U.S. dollar.

That positioning matters because it links U.S. monetary policy directly to global risk premia. When the United States tightens monetary policy—raising interest rates or otherwise making dollar funding more expensive—the dollar tends to strengthen. For investors who are short the dollar, a stronger dollar translates into losses. In the model, those losses reduce arbitrageurs’ net worth.

A hit to net worth is not just an accounting detail. With less capital, arbitrageurs become less able—or less willing—to absorb risk across global markets. The result is an increase in the global “price of risk,” meaning investors require higher compensation to hold risky assets. In practical terms, the model is designed to rationalize why U.S. policy shifts are often associated with broad moves in international asset prices, not only in U.S. markets but across borders and asset classes.

Kekre and Lenel go beyond the theoretical channel by “disciplining” the mechanism—calibrating the model to match the observed effects of U.S. monetary policy on international asset prices. With that disciplined setup, they quantify both the macroeconomic spillovers from U.S. policy and the extent to which policy responses abroad can mitigate or amplify those spillovers.

The analysis also speaks to a forward-looking question: what happens in a world where dollar interest rates are structurally higher than in the recent past? The authors conclude that higher dollar rates would weaken this particular transmission mechanism. In that scenario, arbitrageurs’ reliance on dollar funding is reduced, and the cross-border spillovers from U.S. monetary policy are correspondingly smaller.

The research credits discussions with a wide group of economists, including Mark Aguiar, Yacine Ait-Sahalia, Luigi Bocola, Ricardo Caballero, Pierre-Olivier Gourinchas, Anil Kashyap, Arvind Krishnamurthy, Hyun Song Shin, Alp Simsek, Adrien Verdelhan, and Motohiro Yogo, among others, and acknowledges research assistance from Sviatoslav Tiupin. The work was supported by National Science Foundation grant SES-2446790. The authors note that their conclusions are their own and do not necessarily represent the views of the National Bureau of Economic Research.

Why it matters

Because the dollar sits at the center of the global financial system, changes in U.S. monetary policy can reshape risk-taking well beyond American borders. This model highlights a concrete balance-sheet channel—losses for dollar-short, currency-mismatched arbitrageurs—that can help explain synchronized swings in global asset prices. Investors and policymakers will be watching whether higher long-run U.S. interest rates reduce the world’s sensitivity to Fed tightening, or whether other channels emerge to take its place.