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Financial Integration, Liquidity and Exchange Rates

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Author Info

  • Vittorio Grilli

    (Yale University)

  • Nouriel Roubini

    (NBER)

Abstract

We present a two-country extension of Lucas' (1988) work on how cash-in-advance constraints in asset markets affect the pricing of financial assets. In the model, there is some degree of separation between the goods markets and the assets 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 corresponds to a more appreciated currency. Second, under uncertainty the liquidity effects deriving from stochastic shocks to bond creation lead to an "excess" volatility of nominal 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.

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File URL: http://cowles.econ.yale.edu/P/cd/d09a/d0939.pdf
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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 939.

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Length: 34 pages
Date of creation: Mar 1990
Date of revision:
Handle: RePEc:cwl:cwldpp:939

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Postal: Yale University, Box 208281, New Haven, CT 06520-8281 USA
Phone: (203) 432-3702
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Web page: http://cowles.econ.yale.edu/
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

Related research

Keywords: Asset prices; exchange rates; financial integration; asset markets; capital controls;

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References

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  1. Svensson, Lars E O, 1988. "Trade in Risky Assets," American Economic Review, American Economic Association, vol. 78(3), pages 375-94, June.
  2. Stockman, Alan C. & Svensson, Lars E. O., 1987. "Capital flows, investment, and exchange rates," Journal of Monetary Economics, Elsevier, vol. 19(2), pages 171-201, March.
  3. Jeremy Greenwood & Kent P. Kimbrough, 1987. "An Investigation in the Theory of Foreign Exchange Controls," Canadian Journal of Economics, Canadian Economics Association, vol. 20(2), pages 271-88, May.
  4. Rotemberg, Julio J, 1984. "A Monetary Equilibrium Model with Transactions Costs," Journal of Political Economy, University of Chicago Press, vol. 92(1), pages 40-58, February.
  5. Stockman, Alan C & Hernandez D, Alejandro, 1988. "Exchange Controls, Capital Controls, and International Financial Markets," American Economic Review, American Economic Association, vol. 78(3), pages 362-74, June.
  6. Francesco Giavazzi & Marco Pagano, 1989. "Confidence Crises and Public Debt Management," Working Papers 73, Dipartimento Scienze Economiche, Universita' di Bologna.
  7. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Scholarly Articles 3445091, Harvard University Department of Economics.
  8. Helpman, Elhanan & Razin, Assaf, 1985. "Floating exchange rates with liquidity constraints in financial markets," Journal of International Economics, Elsevier, vol. 19(1-2), pages 99-117, August.
  9. Lars E.O. Svensson, 1987. "Trade in Nominal Assets: Monetary Policy, and Price Level and Exchange Rate Risk," NBER Working Papers 2417, National Bureau of Economic Research, Inc.
  10. Hansson, Ingemar & Stuart, Charles, 1986. "The Fisher Hypothesis and International Capital Markets," Journal of Political Economy, University of Chicago Press, vol. 94(6), pages 1330-37, December.
  11. Robert E. Lucas Jr. & Nancy L. Stokey, 1984. "Money and Interest in Cash-In-Advance Economy," Discussion Papers 628, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  12. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  13. 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.
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Citations

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Cited by:
  1. Ignazio Angeloni & Alessandro Prati, 1996. "The identification of liquidity effects in the EMS: Italy 1991–1992," Open Economies Review, Springer, vol. 7(3), pages 275-293, July.
  2. Grilli, Vittorio & Roubini, Nouriel, 1991. "Financial Intermediation and Monetary Policies in the World Economy," CEPR Discussion Papers 566, C.E.P.R. Discussion Papers.
  3. Alpo Willman, 1991. "Why there is a lower bound on the central bank's foreign reserves," Finnish Economic Papers, Finnish Economic Association, vol. 4(2), pages 113-129, Autumn.

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