Liquidity, Exchange Rates and Policy

University Of Wisconsin-Madison, Madison WI

Investigators

Abstract

Abstract The project consists of three studies that investigate the role of liquid and safe assets in the determination of foreign exchange rates - the value of a country's currency in terms of other currencies. Bonds issued by national governments with sound fiscal policies are generally considered by investors to be safe investments because these bonds have a low chance of default, relatively little price risk, and reflect high transparency about the government. Because these bonds are safe, they are also easily traded - they are liquid. Investors are willing to earn a lower rate of return on government bonds relative to privately issued bonds because they are safe. The difference between the market bond rate and the government bond rate can be referred as "convenience yield". This research looks at the link between convenience yields and exchange rates; examines how international linkages are influenced by the convenience yield and how this affects exchange rates; and appraises the special role of U.S. Treasury assets, which are valued globally for their safety. The first project builds a New Keynesian model that then motivates an empirical model for exchange rates, which is used to investigate exchange rates in major economies. The model uses traditional fundamentals to explain exchange rates: interest rates, and an error correction term for deviations from purchasing power parity. The innovation is to examine the role of the liquidity yield on short-term government bonds, as measured by the difference between the rate of returns on deposits and the government rate. The second project studies how the supply of safe and liquid government bonds influences the dynamics of exchange rates, and how it addresses a number of exchange rate puzzles raised in the literature, in the context of a richer New Keynesian two-country model. The third project concerns the role of constraints on financial institutions, and how they propagate into the determination of foreign exchange rates. As banks all over the world receive substantial short-term funding denominated in U.S. dollars, U.S. short-term Treasuries not only pay interest but provide liquidity to banks. In the model, banks value liquid assets to meet short-term unexpected funding needs. This project documents empirically that during times of particular need for liquidity by banks, the liquidity yield on U.S. Treasury short-term assets is high, and the U.S. dollar is strong. This award reflects NSF's statutory mission and has been deemed worthy of support through evaluation using the Foundation's intellectual merit and broader impacts review criteria.