The implications of liquidity expansion in China for the US dollar

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 price level, 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 in the long run. A monetary model/ECM 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. Increases in the growth rate in the relative US-China M2 forecast a significantly higher value for the US dollar 1- and 6-month later.