Money, Interest Rates, and Exchange Rates: A Segmented Asset Market View

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

We propose to study the connection between money, interest rates, and exchange rates in a model with endogenously segmented markets. In our model agents must pay a fixed cost to transfer money between the asset market and the goods market. This fixed cost leads agents to trade bonds and money only infrequently. In any given period only a fraction of agents are currently actively trading. Thus the asset market is segmented in the sense that when the government injects money through an open market operation only the currently active agents are on the other side of the transaction and only their marginal utilities determine interest rates and exchange rates. Money injections fall disproportionately on these active agents; they increase their current consumption and, hence, real interest rates fall and the real exchange rate depreciates. We contrast the implications of this model with this segmentation effect to a standard one with no market segmentation. We first use this model to study two features of the data on money, inflation, and interest rates that have been discussed extensively in the literature. First, using indexed and nominal bonds, expected inflation and real interest rates move in opposite directions. Second, there has been a long-held belief that open market operations have liquidity effects: money injections lead initially to a decline in short-term nominal interest rates. These liquidity effects are thought to decay over time, with short-term rates eventually returning to normal levels or even rising. Accordingly, money injections are thought to steepen the yield curve, lowering long-term rates less than short-term rates or even raising long-term rates. The VAR literature has been somewhat successful in confirming this pattern in the data. Our model can produce both of these features while the standard model cannot. We show that with relatively moderate amounts of segmentation the model can produce dynamic responses similar to those found in the VAR literature. Moreover, our model can generate persistent real effects from market segmentation even from anticipated shocks. We then use a two-country version of our model to study the variability of nominal and real exchange rates and the forward rate anomaly. For low inflation countries, real exchange rates are persistent, substantially more variable than inflation and interest rate differentials across countries, and movements in nominal and real exchange rates are very similar. The standard model fails to reproduce these observations. Our model can produce volatile and persistent real and nominal exchange rates. Finally, our model can generate the forward premium anomaly, namely the tendency for high interest rate currencies to appreciate. This tendency is puzzling since intuitively one might expect that investors would demand higher interest rates on currencies that are expected to fall in value. The key to generating this anomaly is to have exchange rate risk vary systematically with the level of inflation and interest rates. In the standard model, risk premia are constant. In contrast, in our model endogenous changes in market segmentation lead to systematic changes in risk premia.