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Short-run independence of monetary policy under pegged exchange rates and effects of money on exchange rates and interest rates

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  • Lee E. Ohanian
  • Alan C. Stockman

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.

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Bibliographic Info

Article provided by Federal Reserve Bank of Cleveland in its journal Proceedings.

Volume (Year): (1997)
Issue (Month): ()
Pages: 783-814

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Handle: RePEc:fip:fedcpr:y:1997:p:783-814

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Keywords: Monetary policy ; Money supply;

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References

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  1. Svensson, Lars E O & van Wijnbergen, Sweder, 1989. "Excess Capacity, Monopolistic Competition, and International Transmission of Monetary Disturbances," Economic Journal, Royal Economic Society, vol. 99(397), pages 785-805, September.
  2. Mussa, Michael, 1982. "A Model of Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 90(1), pages 74-104, February.
  3. Alan C. Stockman, 1992. "International Transmission Under Bretton Woods," NBER Working Papers 4127, National Bureau of Economic Research, Inc.
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  8. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  9. Fischer, Stanley, 1977. "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 191-205, February.
  10. Alan C. Stockman, 1978. "A Theory of Exchange Rate Determination," UCLA Economics Working Papers 113, UCLA Department of Economics.
  11. Julio J. Rotemberg, 1982. "A Monetary Equilibrium Model with Transactions Costs," NBER Working Papers 0978, National Bureau of Economic Research, Inc.
  12. Stockman, Alan C. & Stockman, Alan C., 1983. "Real exchange rates under alternative nominal exchange-rate systems," Journal of International Money and Finance, Elsevier, vol. 2(2), pages 147-166, August.
  13. Baxter, Marianne & Stockman, Alan C., 1989. "Business cycles and the exchange-rate regime : Some international evidence," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 377-400, May.
  14. Charles Engel, 1991. "Is real exchange rate variability caused by relative price changes? An empirical investigation," Research Working Paper 91-02, Federal Reserve Bank of Kansas City.
  15. Blanchard, Olivier Jean & Kiyotaki, Nobuhiro, 1987. "Monopolistic Competition and the Effects of Aggregate Demand," American Economic Review, American Economic Association, vol. 77(4), pages 647-66, September.
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  17. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 73(5), pages 871-80, December.
  18. Svensson, Lars E O, 1986. "Sticky Goods Prices, Flexible Asset Prices, Monopolistic Competition, and Monetary Policy," Review of Economic Studies, Wiley Blackwell, vol. 53(3), pages 385-405, July.
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