SHORT-RUN INDEPENDENCE OF MONETARY-POLICY UNDER PEGGED EXCHANGE-RATESAND EFFECTS OF MONEY ON EXCHANGE-RATES AND INTEREST-RATES

This paper examines the effects of money supply changes on exchange ra tes. interest rates, and production in an optimizing two-country model in which some sectors of the economy have predetermined nominal price s in the short run and other sectors have flexible prices. Money suppl y shocks have liquidity effects both within and across countries and i nduce a cross-country real interest differential. The model predicts t hat liquidity effects are highly nonlinear and are not likely to be ca ptured well empirically by linear models. particularly those involving only a single country. A striking implication of the model is that co untries have a significant degree of short-run independence of monetar y policy even under pegged exchange rates.