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Intertemporal Substitution and the Liquidity Effect in a Sticky Price Model

  • J. Andres

    (Banco de Espana and Universidad de Valencia)

  • J. D. Lopez-Salido

    (Banco de Espana)

  • Javier Valles

    (Banco de Espana)

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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Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1698.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1698
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