Time-Varying Liquidity in Foreign Exchange

This paper addresses time-varying liquidity in the foreign exchange market and its relevance for policy. Liquidity is defined here by the price impact of trades: trades have more price impact when markets are less liquid, other things equal. (This usage is standard in theoretical work on trading; see, e.g., Kyle 1985.) Our particular interest is whether currency trades have more price impact when public information is flowing rapidly. This is important for policy:if the answer is yes, it provides a means of increasing the efficacy of intervention (e.g., by selectively timing intervention trades). Central bankers have long suggested that market expectations are at times “ripe” for coordinated adjustment, particularly when new public information arrives. Implicit in this view is the idea that agents draw different conclusions from common macro economic data, making transactions at these times especially valuable for measuring expectations…