When Is Liquidity Bad?

Husnu C. Dalgic ()

CRC TR 224 Discussion Paper Series from University of Bonn and University of Mannheim, Germany

Abstract: Following U.S. monetary policy shocks, exchange rates exhibit two puzzling patterns: they initially depreciate sluggishly (delayed overshooting) before overshooting excessively. I show that incorporating FX speculators with subjective expectations resolves both puzzles by generating short-term momentum and excess volatility in exchange rates. When investors’ expectations are sticky and backward-looking, their trading amplifies the initial sluggishness and subsequent overshooting. In contrast, the participation of investors with rational expectations helps to dampen such volatility. This distinction yields sharp policy implications: limiting the market participation of speculators with subjective expectations significantly lowers exchange rate volatility , while their presence also makes FX interventions and local monetary policy more effective by endogenously reinforcing central bank actions.

Keywords: foreign financiers; capital controls; subjective expectations (search for similar items in EconPapers)
JEL-codes: D84 E44 E71 F32 F41 G15 (search for similar items in EconPapers)
Pages: 63
Date: 2025-12
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
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