When Is Liquidity Bad?

Following U.S. monetary policy shocks, exchange rates exhibit two puzzling patterns: they initially depreciate sluggishly (delayed overshooting) before overshooting excessively. I show that incorporating FX speculators with subjective expectations resolves both puzzles by generating short-term momentum and excess volatility in exchange rates. When investors’ expectations are sticky and backward-looking, their trading amplifies the initial sluggishness and subsequent overshooting. In contrast, the participation of investors with rational expectations helps to dampen such volatility. This distinction yields sharp policy implications: limiting the market participation of speculators with subjective expectations significantly lowers exchange rate volatility , while their presence also makes FX interventions and local monetary policy more effective by endogenously reinforcing central bank actions.