NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Liquidity and Exchange Rates: An Empirical Investigation

Charles Engel, Steve Pak Yeung Wu

NBER Working Paper No. 25397
Issued in December 2018, Revised in May 2019
NBER Program(s):International Finance and Macroeconomics

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.

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Document Object Identifier (DOI): 10.3386/w25397

 
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