Liquidity and Exchange Rates: An Empirical Investigation
67 Pages Posted: 26 Dec 2018 Last revised: 25 May 2023
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Liquidity and Exchange Rates: An Empirical Investigation
Liquidity and Exchange Rates - An Empirical Investigation
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.
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