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Liquidity and Exchange Rates - An Empirical Investigation

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  • Engel, Charles M
  • Wu, Steve Pak Yeung

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 & Wu, Steve Pak Yeung, 2018. "Liquidity and Exchange Rates - An Empirical Investigation," CEPR Discussion Papers 13401, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:13401
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    Cited by:

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    2. Lilley, Andrew & Maggiori, Matteo & Neiman, Brent & Schreger, Jesse, 2019. "Exchange Rate Reconnect," CEPR Discussion Papers 13869, C.E.P.R. Discussion Papers.
    3. Corbo, Vesna & Di Casola, Paola, 2020. "Drivers of consumer prices and exchange rates in small open economies," Working Paper Series 387, Sveriges Riksbank (Central Bank of Sweden).
    4. Maurice Obstfeld, 2020. "Global Dimensions of U.S. Monetary Policy," International Journal of Central Banking, International Journal of Central Banking, vol. 16(1), pages 73-132, February.
    5. Engel, Charles, 2020. "Safe U.S. Assets and U.S. Capital Flows," Journal of International Money and Finance, Elsevier, vol. 102(C).
    6. Lucas Herrenbrueck, 2019. "Interest Rates, Moneyness, and the Fisher Equation," Discussion Papers dp19-01, Department of Economics, Simon Fraser University.
    7. Boris Hofmann & Ilhyock Shim & Hyun Song Shin, 2020. "Bond Risk Premia and The Exchange Rate," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(S2), pages 497-520, December.

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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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