LIQUIDITY, CAPITAL CONTROLS, AND EXCHANGE-RATES

We present a two-country extension of Lucas' (1990) work on how cash-in-advance constraints in asset markets affect the pricing of financial assets. In the model, there is some degree of separation between the goods markets and the asset markets, and money is used for transactions in both markets. The main results of the paper are the following. First, the equilibrium level of the exchange rate depends on the share of money used for asset transactions; a greater share corresponds to a more appreciated currency. Second, capital controls in the form of taxes on foreign asset acquisitions tend to appreciate the exchange rate. Third, the maturity structure of the public debt affects the equilibrium exchange rate. In particular, a move towards a longer maturity structure will tend to depreciate the exchange rate. (JEL 31).