The tightening effect of the zero lower bound on the nominal interest rate is a non-trivial topic in monetary policy: at the zero lower bound, responding to a rise in money growth by reducing the nominal interest rate—what is called the liquidity effect—is not possible because the nominal interest rate cannot be further decreased. However, the absence of the liquidity effect caused by the zero lower bound might amplify the tightening effect of the zero lower bound. I call this tightening effect of the zero lower bound through its liquidity effect on the economy the rebound of liquidity effect, and demonstrate it quantitatively with a simple dynamic stochastic general equilibrium framework.

Currency substitution is a phenomenon that domestic residents use a foreign currency as a medium of exchange. It is a common feature of many developing and transition countries. Many literatures concern the role of currency substitution on the effects of monetary policy and on the real exchange rate fluctuations. In this paper, we analyze the extent to which the degree of currency substitution influences on the effects of monetary policy. Especially, we will focus on the role of real exchange rate in the transmission of monetary policy. To attain this objective, we develop a small open economy general equilibrium model which has a standard New Keynesian framework. Our model also assumes incomplete financial markets in which risk sharing conditions and uncovered interest rate parity condition do not hold and net foreign assets play a role. We derive a tractable model in terms of the output gap, domestic inflation rate and the real exchange rate gap. Our impulse responses and unconditional variances analyses show that the degree of currency substitution does not have serious influences on the effects of domestic monetary policy. This is because the real interest rate channel dominates the marginal utility of consumption channel. On the other hand, it influences on the transmissions of foreign monetary policy shock to the domestic economy. Moreover, in the incomplete financial market, different degree of currency substitution has different permanent effects on the domestic economy through the net foreign assets.