Currency hierarchy, liquidity preference and exchange rates: a Keynesian/minskyan approach
Artigo de Bruno De Conti, André Biancarelli e Pedro Rossi
This paper proposes a theoretical analysis on exchange rates determination based on Keynes and Minsky, and aims at highlighting the role of finance, monetary hierarchy and the international liquidity cycle on exchange rate determination, especially on peripheral currencies. The International Monetary System is hierarchical and the international liquidity of the peripheral currencies depends not so much on the domestic fundamentals but instead depend primarily on the expectations of international agents. Hence, the alternation of moments of higher and lower liquidity preference sets the liquidity cycles and moreover determines moments of “search for yield”, with strong demand for assets in peripheral currencies, and moments of “flight to quality “, with a return to the central currencies. Additionally, it is argued that a liquidity cycle is not restricted to a Keynesian process of asset allocation but also assumes a Minskyan dynamic of liabilities formation. At the upward phase of the cycle, borrowing in credit markets or leveraging in derivatives markets allow the creation of new liquidity in the system. Meantime, in the downward phase, settlement of debts and deleveraging generates a destruction of liquidity in the system. In this context, it is argued that the carry trade is a major mechanism of transmission from liquidity cycle to exchange rates. With these elements, the paper describes a process where carry trade tends to appreciate the peripheral currency – associated with a high interest rates – during the upward phase of the cycle of liquidity and depreciate them in the reversal phase.
Keywords: international finance, currency hierarchy, liquidity cycles, carry trade, exchange rates.