Liquidity Premia and Interest Rate Parity

Ludger Linnemann and Andreas Schabert

No 78, Working Paper Series in Economics from University of Cologne, Department of Economics

Abstract: Due to the US dollar's dominant role for international trade and finance, risk-free assets denominated in US currency not only offer 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 differ 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 modification of uncovered interest rate parity (UIP), which enables the model to explain an appreciation of the dollar subsequent to an increase in US interest rates if foreign interest rates follow the US monetary policy rate.

Keywords: Exchange rate dynamics; uncovered interest rate parity; monetary policy shocks; liquidity premia (search for similar items in EconPapers)
JEL-codes: E4 F31 F41 (search for similar items in EconPapers)
Date: 2014-10-28
New Economics Papers: this item is included in nep-mac, nep-mon and nep-opm
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Journal Article: Liquidity premia and interest rate parity (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:kls:series:0078

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