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Intertemporal substitution and the liquidity effect in a sticky price model

  • Andres, Javier
  • David Lopez-Salido, J.
  • Valles, Javier

The liquidity effect, defined as a decrease in nominal interest rates in response to a monetary expansion, is a major stylized fact of the business cycle. This paper seeks to understand under what conditions such an effect can be explained in a general equilibrium model with sticky prices and capital adjustment costs. The paper first confirms that, with separable preferences, a low degree of intertemporal substitution in consumption is a necessary condition for the existence of the liquidity effect. Contrary to this result, in a model with non-separable preferences and capital accumulation it takes an implausibly high degree of intertemporal substitution to produce a liquidity effect. The robustness of these results to alternative degrees of nominal rigidities, money demand properties and real rigidities is also analyzed.

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Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 46 (2002)
Issue (Month): 8 (September)
Pages: 1399-1421

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Handle: RePEc:eee:eecrev:v:46:y:2002:i:8:p:1399-1421
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