Working Paper: NBER ID: w4517
Authors: Alan C. Stockman; Lee E. Ohanian
Abstract: Economists generally assert that countries sacrifice monetary independence when they peg their exchange rates. At the same time, central bankers frequently assert that pegging an exchange rate does not eliminate the independence of monetary policy. This paper examines the effects of money-supply changes on exchange rates, interest rates, and production in an optimizing two-country model in which some sectors of the economy have predetermined nominal prices in the short run and other sectors have flexible prices. Money-supply shocks have liquidity effects both within and across countries and induce a cross-country real-interest differential. The model predicts that liquidity effects are highly non-linear and are not likely to be captured well empirically by linear models, particularly those involving only a single country. The most striking implication of the model is that countries have a degree of short-run independence of monetary policy even under pegged exchange rates.
Keywords: Monetary Policy; Exchange Rates; Interest Rates; Liquidity Effects
JEL Codes: E52; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Money Supply (E51) | Real Interest Rates (E43) |
| Money Supply (E51) | Nominal Interest Rates (E43) |
| Real Interest Rates (E43) | Cross-Country Real Interest Differential (F29) |
| Monetary Policy (E52) | Exchange Rate Setting (F31) |
| Money Supply (E51) | Liquidity Effects (E41) |
| Liquidity Effects (E41) | Inflation Rates Across Countries (E31) |