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Liquidity and Exchange Rates: Puzzling Evidence from the G-7 Countries

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  • Vittorio Grilli
  • Nouriel Roubini

Abstract

This paper considers the empirical evidence on liquidity effects in open economies; we study the effects of monetary policy shocks (identified by innovations in interest rates) on exchange rates. Both overshooting models with short-run price stickiness and flexible-price models with "liquidity effects" suggest that, in the short-run, the effects of a positive monetary innovation will be a reduction of nominal interest rates and a depreciation of the domestic currency. We consider VAR systems for the G-7 countries and find that, while positive innovations in U.S. interest rates lead to an impact appreciation of the U.S. dollar, positive innovations in the interest rates of the other G-7 countries are associated with an impact depreciation of their currency. We offer two explanations of this "exchange rate puzzle"; one is based on the idea that the U.S. is the "leader" country in the setting of monetary policy for the G-7 area, while the other countries are "follow! ers". The other explanation suggests endogenous policy reaction to underlying inflationary shocks that are a cause of exchange rate depreciation. We then offer some empirical evidence consistent with these two interpretations of the exchange rate puzzle: after controlling for U.S. monetary policies and expected inflation, the response of exchange rates to postive interest rate shocks is a persistent currency appreciation in most of the G-7 countries. Moreover, consistently with both overshooting and liquidity models, a monetary contraction is associated with a transitory appreciation of the real exchange rate and a temporary fall in output.

Suggested Citation

  • Vittorio Grilli & Nouriel Roubini, 1995. "Liquidity and Exchange Rates: Puzzling Evidence from the G-7 Countries," Working Papers 95-17, New York University, Leonard N. Stern School of Business, Department of Economics.
  • Handle: RePEc:ste:nystbu:95-17
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