Liquidity premia: the PPP puzzle's missing piece?

The purchasing power of a given currency varies across countries. Countries’ price levels, measured in USD, diverge significantly. The theoretical literature in Minsky’s tradition explains divergences in the other prices of money (the exchange rate, the interest rate and par) with reference to liquidity premia and monetary hierarchy. This argument has not been connected to the price level, which can be defined as the relationship between exchange rates and purchasing power parity rates. This essay presents a hypothesis for that missing connection: Different currencies with different degrees of liquidity are used as a store of value and international means of payment to different degrees. The resulting divergence between the demand for money in the foreign exchange market and the demand for money in the market for commodities moves the market exchange rate away from a level that would equalize purchasing power rates across countries. Based on a review of the Post-Keynesian literature on the links between interest rates and exchange rates, I develop an empirical measure for currencies’ liquidity premia in the foreign exchange market. I use it to empirically test my hypothesis, which I formalize as a simple regression model. My results suggest that the hypothesized effect is small, but significant. This finding points to a causal link between currency hierarchy and ecologically unequal exchange.