Liquidity and Exchange Rates

Abstract

This paper studies the predictive power of several proxies for liquidity in forecasting exchange rates for a set of countries from January 2001 to April 2013. The results indicate that changes in funding liquidity of U.S. financial intermediaries impact exchange rates around the globe; however, the type of funding and its relevance in explaining exchange rate movements vary across time. Public liquidity represented by U.S. monetary aggregates is not robustly significant in forecasting exchange rate changes across time, countries or forecasting horizons. By contrast, the long-term interest rate and risk taking indicators have robust in-sample and out-of-sample predictive power with respect to exchange rates. Finally, the paper confirms that dynamic factors extracted from a panel of several liquidity indicators are useful in predicting exchange rate movements.