Short-Run Independence of Monetary Policy under Pegged Exchange Rates and Effects of Money on Exchange Rates and Interest Rates

By Ohanian, Lee E.; Stockman, Alan C. | Journal of Money, Credit & Banking, November 1997 | Go to article overview

Short-Run Independence of Monetary Policy under Pegged Exchange Rates and Effects of Money on Exchange Rates and Interest Rates


Ohanian, Lee E., Stockman, Alan C., Journal of Money, Credit & Banking


This paper examines the effects of money supply changes on exchange rates, interest rates, and production in an optimizing two-country model in which some sectors of the economy have predetermined nominal prices in the short run and other sectors have flexible prices. Money supply shocks have liquidity effects both within and across countries and induce a cross-country real interest differential. The model predicts that liquidity effects are highly nonlinear and are not likely to be captured well empirically by linear models, particularly those involving only a single country. A striking implication of the model is that countries have a significant degree of shortrun independence of monetary policy even under pegged exchange rates.

This paper examines the effects of money-supply changes in a two-country world in which some sectors of the economy have nominal prices that are sticky in the short run and other sectors have perfectly flexible prices. We examine the short-run effects of changes in the money supply on the exchange rate, home and foreign real and nominal interest rates, the pattern of trade, and production in each sector and in each country. We show that money supply changes have liquidity effects (a fall in the money supply raises the real and nominal interest rate) both within and across countries, and introduce a cross-country real interest differential. We also show how a country can exercise independent monetary policy, in the short run, while it pegs its exchange rate to another country. Similarly, the model shows why a credible target zone for the exchange rate provides much less of a short-run constraint on monetary policy than is commonly believed.

Economists currently lack an empirically satisfactory model of exchange rates. Many theoretical models assign a large role to monetary disturbances, operating through mechanisms closely related to that discussed in the classic contribution of Dornbusch (1976). Other theoretical models (for example, Stockman 1980 and Lucas 1982) assign a larger role to real disturbances that affect equilibrium relative prices and induce exchange rate changes to create them. Recent empirical evidence suggests that exchange rates may contain a mean-reverting component with a half-life of approximately three years (for example, Huizinga 1987, Cumby and Huizinga 1990, and Mark 1995). Yet current theoretical models that focus on the effects of changes in money in understanding changes in international interest-differentials and exchange rates have not successfully explained these persistent changes in exchange rates. Similarly, equilibrium models of exchange rates have not been successful in explaining the observed differences in relative price behavior across alternative exchange rate systems (see Stockman 1983, Mussa 1986, and Baxter and Stockman 1989). Moreover, there are no formal explanations with either class of models of the apparent short-run independence of monetary policy that countries can exercise under pegged exchange rates, or under systems of limited exchange rate flexibility such as the EMS.

This paper develops an alternative theoretical framework in which monetary disturbances may play an important role in affecting interest rates and exchange rates. Unlike most previous research on the real effects of monetary shocks that has focused on a one-sector macroeconomic model (such as Dornbusch 1976 and Mussa 1982), we examine a two-sector model and allow the two sectors to have different degrees of price flexibility. In this paper, we examine the starkest case in which one sector's price is completely sticky in the short run, and the other sector's price is completely flexible.

Our interest in this two-sector model follows from the empirical finding that nominal price flexibility varies considerably across different goods. For example, there appear to be certain goods with prices that change very infrequently, as documented by Blinder (1991), Carlton (1989), Cecchetti (1986), and Kashyap (1991). …

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