Money, Interest Rates, and Exchange Rates with Endogenously Segmented Markets

We analyze the effects of money injections on interest rates and exchange rates when agents must pay a Baumol‐Tobin‐style fixed cost to exchange bonds and money. Asset markets are endogenously segmented because this fixed cost leads agents to trade bonds and money infrequently. When the government injects money through an open market operation, only those agents that are currently trading absorb these injections. Through their impact on these agents’ consumption, these money injections affect real interest rates and real exchange rates. The model generates the observed negative relation between expected inflation and real interest rates as well as persistent liquidity effects in interest rates and volatile and persistent exchange rates.