Liquidity and Exchange Rates: An Empirical Investigation

67 Pages Posted: 26 Dec 2018 Last revised: 25 May 2023

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

Steve Pak Yeung Wu

University of Wisconsin - Madison - Department of Economics

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Date Written: December 2018

Abstract

We find strong empirical evidence that economic fundamentals can well account for nominal exchange rate movements. The important innovation is that we include the liquidity yield on government bonds as an explanatory variable. We find impressive evidence that changes in the liquidity yield are significant in explaining exchange rate changes for all of the G10 countries. Moreover, after controlling for liquidity yields, traditional determinants of exchange rates – adjustment toward purchasing power parity and monetary shocks – are also found to be economically and statistically significant. We show how these relationships arise out of a canonical two-country New Keynesian model with liquidity returns. Additionally, we find a role for sovereign default risk and currency swap market frictions.

Suggested Citation

Engel, Charles M. and Wu, Steve Pak Yeung, Liquidity and Exchange Rates: An Empirical Investigation (December 2018). NBER Working Paper No. w25397, Available at SSRN: https://ssrn.com/abstract=3306109

Charles M. Engel (Contact Author)

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Steve Pak Yeung Wu

University of Wisconsin - Madison - Department of Economics ( email )

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