Liquidity and Exchange Rates: An Empirical Investigation

We find strong empirical evidence that the liquidity yield on government bonds in combination with standard economic fundamentals can well account for nominal exchange rate movements. We find impressive evidence that changes in the liquidity yield are significant in explaining exchange rate changes for all the G10 countries, and we stress that the US dollar is not special in this relationship. 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.