Working Paper: NBER ID: w3088
Authors: Vittorio Grilli; Nouriel Roubini
Abstract: This paper presents a two-country extension of Lucas' (1988) work on the effects of cash-in-advance constraints in asset markets on the pricing of financial assets. The model is one where there exists some degree of separation between the goods markets and the asset markets and money is used for transactions in both markets. The main results of the paper are the following. First, the equilibrium level of the exchange rate depends on the share of money used for asset transactions: a greater share will correspond to a more appreciated exchange rate. Second, under uncertainty, liquidity effects deriving from stochastic shocks to bond creation lead to an "excess" volatility of nominal and real exchange rates even when the "fundamental" value of the exchange rate is constant. Third, capital controls in the form of taxes on foreign asset acquisitions tend to appreciate the exchange rate. Fourth, the maturity structure of the public debt affects the equilibrium exchange rate. In particular, a move towards a longer maturity structure will tend to depreciate the exchange rate.
Keywords: Financial Integration; Liquidity; Exchange Rates
JEL Codes: F31; F36
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| share of money used for asset transactions (G32) | equilibrium exchange rate (F31) |
| liquidity effects from stochastic shocks to bond creation (E44) | excess volatility of nominal and real exchange rates (F31) |
| capital controls (taxes on foreign asset acquisitions) (F38) | appreciation of the exchange rate (F31) |
| longer maturity structure of public debt (H63) | depreciation of the exchange rate (F31) |