AND EFFECTS OF MONEY ON EXCHANGE RATES AND INTEREST RATES

Economists generally assert that countries sacrifice monetary independence when they peg their exchange rates. At the same time, central bankers frequently assert that pegging an exchange rate does not eliminate the independence of monetary policy. 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 non-linear and are not likely to be captured well empirically by linear models, particularly those involving only a single country. The most striking implication of the model is that countries have a degree of short-run independence of monetary policy even under pegged exchange rates