International Liquidity and Exchange Rate Dynamics

67 Pages Posted: 7 Dec 2013 Last revised: 21 Jul 2015

See all articles by Xavier Gabaix

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Matteo Maggiori

Harvard University; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: November 1, 2014

Abstract

We provide a theory of the determination of exchange rates based on capital flows in imperfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus impacting both the level and volatility of exchange rates. Our theory of exchange rate determination in imperfect financial markets not only rationalizes the empirical disconnect between exchange rates and traditional macroeconomic fundamentals, but also has real consequences for output and risk sharing. Exchange rates are sensitive to imbalances in financial markets and seldom perform the shock absorption role that is central to traditional theoretical macroeconomic analysis. We derive conditions under which heterodox government financial policies, such as currency interventions and taxation of capital flows, can be welfare improving. Our framework is flexible; it accommodates a number of important modeling features within an imperfect financial market model, such as non-tradables, production, money, sticky prices or wages, various forms of international pricing-to-market, and unemployment.

Keywords: Exchange Rate Disconnect, Capital Flows, FX Intervention, Limits of Arbitrage

JEL Classification: E42, E44, F31, F32, F41, F42, G11, G15, G20

Suggested Citation

Gabaix, Xavier and Maggiori, Matteo, International Liquidity and Exchange Rate Dynamics (November 1, 2014). Available at SSRN: https://ssrn.com/abstract=2364086 or http://dx.doi.org/10.2139/ssrn.2364086

Xavier Gabaix (Contact Author)

Harvard University - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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Centre for Economic Policy Research (CEPR)

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European Corporate Governance Institute (ECGI)

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Matteo Maggiori

Harvard University ( email )

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Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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