Liquidity and Exchange Rates

This 1992 Journal of International Economics paper by Vittorio Grilli and Nouriel Roubini builds a two-country extension of Lucas’s (1988) cash-in-advance model of asset-market liquidity, in which representative households must hold not only money to buy goods but also money to buy bonds, with trips to the goods market and the asset market occurring simultaneously but through physically separate household members. The paper’s central finding is that the equilibrium nominal exchange rate depends directly on each country’s “share of money used for asset transactions”: a country where a larger fraction of the money stock is tied up buying bonds has a more appreciated currency, because less money is left over to chase goods and bid up the domestic price level. From this mechanism the paper derives three comparative-statics results – capital controls (modeled as a tax on foreign bond purchases) appreciate the taxing country’s currency; a shift toward longer-maturity public debt depreciates the currency, because less money needs to be held against each period’s bond issuance; and, once the size of each period’s bond issuance is made stochastic, purely liquidity-driven “excess” volatility in interest rates (Lucas’s result for a closed economy) spills over one-for-one into excess volatility of nominal and real exchange rates even when every real fundamental in the economy is constant. (Note on sourcing: the full text located for this summary is the paper’s own NBER working-paper draft, “Financial Integration, Liquidity and Exchange Rates” (NBER WP 3088, August 1989) – the 1992 journal article’s own published abstract cites this working paper as its direct predecessor and restates the same four results, so the draft and the published version are treated here as the same paper under an editorially shortened title.)

Vittorio Grilli | Macro Paper Warehouse

Liquidity and Exchange Rates