LIQUIDITY AND EXCHANGE-RATES

We present a two-country extension of Lucas's (1988a) work on cash-in-advance constraints in asset markets. In the model there is temporary separation between the goods and asset markets, and money is used for transactions in both. We first find that the exchange rate level depends on the share of money used for asset transactions; a greater share appreciates the currency. Second, stochastic open market operations increasing the domestic bonds' supply appreciate the domestic currency. Third, the liquidity effects of bond supply shocks cause an 'excess' volatility of nominal exchange rates, even when their 'fundamental' value is constant.