International Macroeconomics and Liquidity

The massive stocks of foreign exchange reserves, mostly held in the form of U.S. T-bills by emerging economies are still an important puzzle. Why do emerging economies continue to willingly loan to the United States despite low rates of return? The first chapter argues that a model incorporating international capital markets, characterized by a non-centralized trading mechanism and U.S. T-bills as facilitators of trade, can provide an answer to this question. Declining financial frictions in these particular markets would generate rising liquidity premiums on U.S. T-bills. Meanwhile, the higher liquidity properties of the U.S. T-bills would induce recipients of foreign investments, namely emerging economies, to hold more of the liquidity (i.e., the U.S. T-bills) in equilibrium.;One of the main verifiable implications of the model I discussed in the first chapter is that foreign investments through OTC markets could hold a potential key in understanding recent reserve growth by emerging economies. This chapter tests this hypothesis for a collection of 53 emerging economies using data spanning the years 1997 to 2007. Employing the dynamic panel estimation method, I find support for the liquidity-based explanation for the recent upsurge in reserve holdings of emerging economies. Out-of-sample forecasts based on my model specification also can successfully explain the recent reserve accumulation quantitatively. This finding provides new insight into current policy debates regarding the fact that reserve adequacy should also be gauged against the amount of bilateral foreign investment trading associated with the newly developed instruments and markets (e.g., private equity investment into emerging markets).;The last chapter turns attention to foreign exchange rate markets (FOREX). The FOREX market is an over-the-counter (OTC) market characterized by bilateral trade, intermediation, and positive bid-ask spreads. The traditional international macroeconomics literature has failed to account for these characteristics largely due to the fact that it models the FOREX as a standard Walrasian (perfectly competitive) market, therefore overlooking some important institutional details of this market. As a response, a recent strand of the international finance literature, known as FOREX microstructure, has focused on the details and importance of the mechanics of FOREX trading. Although the microstructure literature has given us fruitful insights on many aspects of the FOREX rate determination, it has neglected the role of macroeconomic fundamentals, which is arguably very important for the determination of exchange rates in the long-run. The main goal of this chapter is to bridge this gap. This chapter develops a dynamic general equilibrium two-country model, where trade in each country necessitates the use of local currency. Agents with a foreign consumption opportunity can acquire foreign currency in an intermediated exchange market that resembles the OTC market of Duffie, Garleanu, and Pedersen (2005). Positive bid-ask spreads arise in equilibrium because intermediators are the only agents with access to a frictionless interdealer market. The model allows us to study how standard measures of FOREX market liquidity, such as bid-ask spreads and trade volume, are affected by both macroeconomic fundamentals and the market microstructure. Among other results, it is found that: a) an increase in either country's inflation raises the bid-ask spreads; b) an increase in either country's inflation decreases the total trade volume in the FOREX market; and c) an increase in the bargaining power of intermediators raises the buyer-intermediator trade volume, but lowers the interdealer trade volume.