Authors: Hörmann, Markus
Title: Liquidity premia, interest rates and exchange rate dynamics
Language (ISO): en
Abstract: Empirical failure of uncovered interest rate parity (UIP) has become a stylized fact. VARs by Eichenbaum and Evans (1995) and Scholl and Uhlig (2008) find delayed overshooting of the exchange rate in response to a monetary shock. This result contradicts Dornbusch’s (1976) original overshooting, which is based on UIP. This paper presents a model in which assets eligible for central bank’s open market operations, such as government bonds, command liquidity premia. Further, I allow for a key currency which is required to participate in international goods trade. Therefore, assets allowing access to key currency liquidity are held by agents around the globe. I show that liquidity premia lead to a modified UIP condition. In response to a monetary policy shock, the model predicts delayed overshooting of the nominal exchange rate, as in Eichenbaum and Evans (1995).
Subject Headings: monetary policy
uncovered interest rate parity
liquidity premium
key currency
Issue Date: 2011-04-12
Appears in Collections:Sonderforschungsbereich (SFB) 823

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