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Money, interest rates, and exchange rates with endogenously segmented markets

Author

Listed:
  • Fernando Alvarez
  • Andrew Atkeson
  • Patrick J. Kehoe

Abstract

This paper analyzes the effects of money injections on interest rates and exchange rates in a model in which agents must pay a Baumol-Tobin style fixed cost to exchange bonds and money. Asset markets are endogenously segmented because this fixed cost leads agents to trade bonds and money only infrequently. When the government injects money through an open market operation, only those agents that are currently trading absorb these injections. Through their impact on these agents? consumption, these money injections affect real interest rates and real exchange rates. We show that the model generates the observed negative relation between expected inflation and real interest rates. With moderate amounts of segmentation, the model also generates other observed features of the data: persistent liquidity effects in interest rates and volatile and persistent exchange rates. A standard model with no fixed costs can produce none of these features.

Suggested Citation

  • Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, . "Money, interest rates, and exchange rates with endogenously segmented markets," Staff Report, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmsr:278
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    3. Morand, Olivier F. & Reffett, Kevin L., 2003. "Existence and uniqueness of equilibrium in nonoptimal unbounded infinite horizon economies," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1351-1373, September.
    4. Lee Ohanian, 2000. "EconomicDynamics Interviews Lee Ohanian on the Great Depression," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 1(2), April.
    5. José García-Solanes & Jesús Rodríguez-López & José Torres, 2011. "Demand Shocks and Trade Balance Dynamics," Open Economies Review, Springer, vol. 22(4), pages 739-766, September.
    6. Jonathan Chiu & Miguel Molico, 2011. "Uncertainty, Inflation, and Welfare," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43, pages 487-512, October.
    7. Thi Hong Hanh Pham, 2018. "Liquidity and exchange rate volatility," Working Papers halshs-01708633, HAL.
    8. Herrenbrueck, Lucas & Geromichalos, Athanasios, 2017. "A tractable model of indirect asset liquidity," Journal of Economic Theory, Elsevier, vol. 168(C), pages 252-260.
    9. Rocheteau, Guillaume & Wright, Randall & Xiaolin Xiao, Sylvia, 2018. "Open market operations," Journal of Monetary Economics, Elsevier, vol. 98(C), pages 114-128.
    10. Fernando Alvarez & Robert E. Lucas & Warren E. Weber, 2001. "Interest Rates and Inflation," American Economic Review, American Economic Association, vol. 91(2), pages 219-225, May.
    11. Edward C. Prescott, 2003. "Non-convexities in quantitative general equilibrium studies of business cycles," Staff Report, Federal Reserve Bank of Minneapolis.
    12. Stephen D. Williamson, 2009. "Transactions, Credit, and Central Banking in a Model of Segmented Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(2), pages 344-362, April.
    13. repec:pri:wwseco:dp229 is not listed on IDEAS
    14. Harald Uhlig, 2001. "EconomicDynamics Interviews Harald Uhlig on Dynamic Contracts," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 2(2), April.
    15. Russell Cooper & Hubert Kempf, 2004. "Overturning Mundell: Fiscal Policy in a Monetary Union," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 71(2), pages 371-396.
    16. Jonathan A. Parker & Christian Julliard, 2003. "Consumption Risk and Cross-Sectional Returns," NBER Working Papers 9538, National Bureau of Economic Research, Inc.
    17. Mahmoudi, Babak, 2013. "Open-Market Operations, Asset Distributions, and Endogenous Market Segmentation," MPRA Paper 50089, University Library of Munich, Germany.

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