DP13401 Liquidity and Exchange Rates - An Empirical Investigation

Author(s): Charles M Engel, Steve Pak Yeung Wu
Publication Date: December 2018
Date Revised: December 2018
JEL(s): F31, F41
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13401

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.