LIQUIDITY, EXCHANGE-RATES, AND BUSINESS CYCLES

This paper presents a two-country, two-good, two-currency model to study the role of liquidity effects in exchange rate determination and the international transmission of economic fluctuations. The model provides an exchange rate equation which is different from the simple purchasing-power-parity law of exchange rate determination. Both monetary injections and real disturbances can lead to exchange rate fluctuations and comovements of interest rates, prices, and output of the two economies. Whether the covariances of variables in the two countries are positive, negative, or zero depends critically upon the substitutability of the two consumption goods in consumers' preferences.