Working Paper: NBER ID: w25397
Authors: Charles Engel; Steve Pak Yeung Wu
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.
Keywords: Liquidity; Exchange Rates; Government Bonds; New Keynesian Model
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| liquidity yield influences exchange rates (F31) | investment decisions (G11) |
| liquidity yield on government bonds (E43) | exchange rate movements (F31) |
| increase in liquidity yield (E43) | currency appreciation (F31) |
| liquidity yields (E41) | traditional determinants such as interest rate differentials and adjustments towards purchasing power parity (F31) |