The Implications of Liquidity Expansion in China for the US Dollar
36 Pages Posted: 29 Jan 2016 Last revised: 3 Feb 2016
Date Written: January 27, 2016
The value of the US dollar is of major importance to the world economy. Global liquidity has grown sharply in recent years with growing importance of China’s money supply to global liquidity. We develop out-of-sample forecasts of the US dollar exchange rate value using US and non-US global data on inflation, output, interest rates, and liquidity on the US, China and non-US/non-China liquidity. Monetary model forecasts significantly outperform a random walk forecast in terms of MSFE at horizons over 12 to 30 months ahead. A monetary model with sticky prices performs best. Rolling sample analysis indicates changes over time in the influence of variables in forecasting the US dollar. China’s liquidity has a distinct, significant and changing influence on the US dollar exchange rate. Post global financial crisis, increases in the growth rate in China’s M2 forecast a significantly higher value for the US dollar 12 months and 18 months ahead and significantly lower values for the US dollar 24 and 30 months ahead.
Keywords: China’s liquidity, trade-weighted US dollar, forecasting US dollar exchange rate
JEL Classification: E41, E51, F31, F41
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