Template-Type: ReDIF-Paper 1.0
Title: When Is Liquidity Bad?
Author-Name: Husnu C. Dalgic
Author-Email: dalgic@uni-mannheim.de

Classification-JEL:   E44, F32, F41, G15, D84, E71


Keywords: foreign financiers, capital controls, subjective expectations


Abstract: Following U.S. monetary policy shocks, exchange rates exhibit two puzzling patterns: they initially depreciate sluggishly (delayed overshooting) before overshooting
excessively. I show that incorporating FX speculators with subjective expectations resolves both puzzles by generating short-term momentum and excess volatility in
exchange rates. When investors’ expectations are sticky and backward-looking, their trading amplifies the initial sluggishness and subsequent overshooting. In contrast,
the participation of investors with rational expectations helps to dampen such volatility. This distinction yields sharp policy implications: limiting the market participation
of speculators with subjective expectations significantly lowers exchange rate volatility , while their presence also makes FX interventions and local monetary policy more
effective by endogenously reinforcing central bank actions.

Note: 
Length: 63
Creation-Date: 2025-12
Revision-Date: 
File-URL: https://www.crctr224.de/research/discussion-papers/archive/dp723
File-Format: application/pdf
Handle: RePEc:bon:boncrc:CRCTR224_2025_723