Liquidity yield and exchange rate predictability*

In this paper, we extend the Taylor rule model of exchange rate determination by incorporating the liquidity yield on government bonds, and investigate exchange rate predictability from the augmented Taylor rule model. We find that the liquidity yield on government bonds delivers additional predictive power to future exchange rate movements beyond the model with Taylor rule fundamentals, using both in-sample and out-of-sample tests. In particular, the augmented model with liquidity yield exhibits superior predictive power after the currency swap market frictions are controlled.