,17(57(0325$/68%67,787,21$1'7+(/,48,',7<())(&7 ,1$67,&.<35,&(02'(/ J. Andrés (1) , J.D. López-Salido (2) and J. Vallés (2) (1) %DQFRGH(VSDxDDQG8QLYHUVLGDGGH9DOHQFLD (2) %DQFRGH(VSDxD5HVHDUFK'HSDUWPHQW September 1999 $EVWUDFW 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. .H\ZRUGV intertemporal substitution, liquidity effect, price and capital adjustment costs. -(/&ODVVLILFDWLRQ E32, E43. &RUUHVSRQGLQJ DXWKRU Javier Vallés, Research Department Banco de España, Alcalá 50, 28014 Madrid, Spain. E-mail: valles@bde.es  We owe special thanks to Larry Christiano, Jordi Galí, Robert Kollmann and Sergio Rebelo for very helpful comments and suggestions. We also thank Isabel Correia, Olivier Jeanne, Albert Marcet, Stephanie Smitt-Grohé and Pedro Teles for insightful conversations, and seminar participants at Banco de Portugal, CEPR 1999 European Summer Symposium in Macroeconomics (Sintra), and the Society for Economic Dynamics 1999 Annual Meeting (Alghero) for comments. The views expressed in this paper are the authors' and do not necessarily reflect those of the %DQFRGH(VSDxD.