Intertemporal Substitution and the Liquidity Effect in a Sticky Price Model

Abstract

The liquidity effect, defined as a decrease in nominal interest rates in response to a monetary expansion, is a major stylized fact of the business cycle. This paper seeks to understand under what conditions such an effect can be explained in a general equilibrium model with sticky prices and capital adjustment costs. The paper first confirms that, with separable preferences, a low degree of intertemporal substitution in consumption is a necessary condition for the existence of the liquidity effect. Contrary to this result, in a model with non-separable preferences and capital accumulation it takes an implausibly high degree of intertemporal substitution to produce a liquidity effect. The robustness of these results to alternative degrees of nominal rigidities, money demand properties and real rigidities is also analyzed.