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Liquidity premia and interest rate parity

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  • Linnemann, Ludger
  • Schabert, Andreas

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 transaction 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.

Suggested Citation

  • Linnemann, Ludger & Schabert, Andreas, 2015. "Liquidity premia and interest rate parity," Journal of International Economics, Elsevier, vol. 97(1), pages 178-192.
    • Handle: RePEc:eee:inecon:v:97:y:2015:i:1:p:178-192
    DOI: 10.1016/j.jinteco.2015.03.006
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    Cited by:

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    2. M. Utku Ozmen & Erdal Yilmaz, 2016. "Co-movement of Exchange Rates with Interest Rate Differential, Risk Premium and FED Policy in �Fragile Economies�," Working Papers 1621, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
    3. Christian Bredemeier & Christoph Kaufmann & Andreas Schabert, 2017. "Interest Rate Spreads and Forward Guidance," Working Paper Series in Economics 96, University of Cologne, Department of Economics.
    4. Charles Engel & Steve Pak Yeung Wu, 2023. "Liquidity and Exchange Rates: An Empirical Investigation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 90(5), pages 2395-2438.
    5. Seungduck Lee & Kuk Mo Jung, 2019. "A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle," Working Papers 1902, Nam Duck-Woo Economic Research Institute, Sogang University (Former Research Institute for Market Economy).
    6. Seungduck Lee & Kuk Mo Jung, 2020. "A Liquidity‐Based Resolution of the Uncovered Interest Parity Puzzle," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 52(6), pages 1397-1433, September.
    7. Christian Bredemeier & Falko Juessen & Andreas Schabert, 2021. "Why Are Fiscal Multipliers Moderate Even Under Monetary Accommodation?," ECONtribute Discussion Papers Series 074, University of Bonn and University of Cologne, Germany.
    8. Hafiz Waqas Kamran & Dr. Shamsul Bahrain bin Mohamed Arshad & Dr. Abdelnaser Omran, 2019. "Liquidity Risk Management in Banking Sector under the Shadow of Systematic Risk and Economic Dynamics in Pakistan," Pakistan Journal of Humanities and Social Sciences, International Research Alliance for Sustainable Development (iRASD), vol. 7(2), pages :167-183, June.
    9. Lucas Herrenbrueck, Zijian Wang, 2023. "Interest Rates, Moneyness, and the Fisher Equation," Discussion Papers dp23-11, Department of Economics, Simon Fraser University.
    10. Özmen, M. Utku & Yılmaz, Erdal, 2017. "Co-movement of exchange rates with interest rate differential, risk premium and FED policy in “fragile economies”," Emerging Markets Review, Elsevier, vol. 33(C), pages 173-188.
    11. Chouchène, Mabrouk & Ftiti, Zied & Khiari, Wided, 2017. "Bank-to-bank lending channel and the transmission of bank liquidity shocks: Evidence from France," Research in International Business and Finance, Elsevier, vol. 39(PB), pages 940-950.
    12. Musa, Abdullahi & Salisu, Afees A. & Aliyu, Victoria O. & Mevweroso, Chioma R., 2021. "Analysis of asymmetric response of exchange rate to interest rate differentials: The case of African Big 4," The North American Journal of Economics and Finance, Elsevier, vol. 55(C).
    13. Adewuyi, Adeolu O. & Ogebe, Joseph O., 2019. "The validity of uncovered interest parity: Evidence from african members and non-member of the organisation of petroleum exporting countries (OPEC)," Economic Modelling, Elsevier, vol. 82(C), pages 229-249.

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    More about this item

    Keywords

    Exchange rate dynamics; Uncovered interest rate parity; Monetary policy shocks; Liquidity premia;
    All these keywords.

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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