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Liquidity premia and interest rate parity

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  • Linnemann, Ludger
  • Schabert, Andreas

Abstract

Due to the US dollar's dominant role for international trade and finance, risk-free assets denominated in US currency not only offer a pecuniary return, but also provide transaction services, both nationally and internationally. Accordingly, the responses of bilateral US dollar exchange rates to interest rate shocks should differ substantially with respect to the (US or foreign) origin of the shock. We demonstrate this empirically and apply a model of liquidity premia on US treasuries originating from monetary policy implementation. The liquidity premium leads to a modification of uncovered interest rate parity (UIP), which enables the model to explain an appreciation of the dollar subsequent to an increase in US interest rates if foreign interest rates follow the US monetary policy rate.

Suggested Citation

  • Linnemann, Ludger & Schabert, Andreas, 2015. "Liquidity premia and interest rate parity," Journal of International Economics, Elsevier, vol. 97(1), pages 178-192.
  • Handle: RePEc:eee:inecon:v:97:y:2015:i:1:p:178-192
    DOI: 10.1016/j.jinteco.2015.03.006
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    Cited by:

    1. Özmen, M. Utku & Yılmaz, Erdal, 2017. "Co-movement of exchange rates with interest rate differential, risk premium and FED policy in “fragile economies”," Emerging Markets Review, Elsevier, vol. 33(C), pages 173-188.
    2. Christian Bredemeier & Christoph Kaufmann & Andreas Schabert, 2017. "Interest Rate Spreads and Forward Guidance," Working Paper Series in Economics 96, University of Cologne, Department of Economics.
    3. Charles Engel & Steve Pak Yeung Wu, 2018. "Liquidity and Exchange Rates: An Empirical Investigation," NBER Working Papers 25397, National Bureau of Economic Research, Inc.
    4. Chouchène, Mabrouk & Ftiti, Zied & Khiari, Wided, 2017. "Bank-to-bank lending channel and the transmission of bank liquidity shocks: Evidence from France," Research in International Business and Finance, Elsevier, vol. 39(PB), pages 940-950.

    More about this item

    Keywords

    Exchange rate dynamics; Uncovered interest rate parity; Monetary policy shocks; Liquidity premia;

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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