Liquidity premia and interest rate parity

Abstract

Risk-free assets denominated in US currency not only o¤er a pecuniary return, but also provide transactions services, both nationally and internationally. Accordingly, the responses of bilateral US dollar exchange rates to interest rate shocks should di¤er substantially with respect to the (US or foreign) origin of the shock. We demonstrate this empirically and apply a model of liquidity premia on US treasuries originating from monetary policy implementation. The liquidity premium leads to a modi…cation of uncovered interest rate parity (UIP), which is able to explain observed deviations of exchange rate dynamics from UIP predictions. In line with empirical evidence, the model predicts an appreciation of the US dollar subsequent to an increase in US interest rates as well as in SOE interest rates.JEL classi…cation: E4; F31; F41.

Why are fiscal multipliers moderate even under monetary accommodation?

“…These results are confirmed under a regime with the nominal policy rate at the ZLB. Here, a decline in the real policy rate is induced by the fixation of the nominal policy rate and leads to large This is shown by Bredemeier et al (2020), who further provide consistent empirical evidence on changes in liquidity premia after unanticipated monetary policy announcements, and by Linnemann and Schabert (2015), who find that liquidity premia help explain observed exchange rate responses to monetary policy shocks. Notably, our model with the liquidity premium also implies that an increase in a labor income tax rate at the ZLB leads to contractionary effects, whereas a model without the liquidity premium paradoxically predicts expansionary effects (as in Eggertsson, 2011).…”

Monetary Policy and Exchange Rates: A Balanced Two-Country Cointegrated Var Model Approach

“…2. Linnemann and Schabert (2015) find with their theoretical model a delayed response of the exchange rate mainly for a monetary policy shock originated in the United States, what they explain with liquidity premia on short-term treasuries.…”

Interest rate spreads and forward guidance

“…In their model, forward guidance does not foster recovery, but only leads to increases in risk premia in their setting, which relates to the rise in liquidity premia implied by our model. A liquidity premium stemming from eligibility of certain assets in open market operations (which we apply for the analysis of forward guidance effects) has been shown by Linnemann and Schabert (2015) and Bredemeier et al (2017) to explain the observed delayed overshooting of exchange rates and to reconcile theory and evidence on the role of monetary policy for the fiscal multiplier, respectively.…”