The Implications of Liquidity Expansion in China for the US Dollar

36 Pages Posted: 29 Jan 2016 Last revised: 3 Feb 2016

Wensheng Kang

Kent State University - Department of Economics

Ronald A. Ratti

Western Sydney University - Department of Economics & Finance

Joaquin L. Vespignani

University of Tasmania - School of Economics and Finance

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Date Written: January 27, 2016

Abstract

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

Suggested Citation

Kang, Wensheng and Ratti, Ronald A. and Vespignani, Joaquin L., The Implications of Liquidity Expansion in China for the US Dollar (January 27, 2016). CAMA Working Paper No. 5/2016. Available at SSRN: https://ssrn.com/abstract=2723723 or http://dx.doi.org/10.2139/ssrn.2723723

Wensheng Kang

Kent State University - Department of Economics ( email )

Kent, OH 44242
United States

Ronald A. Ratti

Western Sydney University - Department of Economics & Finance ( email )

Sydney, NSW 1797
Australia

Joaquin L. Vespignani (Contact Author)

University of Tasmania - School of Economics and Finance ( email )

Commerce Building,
Sandy Bay Campus
Sandy Bay, TAS, Tasmania 7005
Australia

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