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A fundamental theory of exchange rates and direct currency trades

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  • Head, Allen
  • Shi, Shouyong

Abstract

In this paper we construct a two-country search model to determine the nominal exchange rate between two fiat monies. Our model allows agents to use any currency to trade for goods in all countries. However, search frictions restrict agents opportunities for instantaneous arbitrage, and hence make the nominal exchange rate determinate. The nominal exchange rate depends on the two countries economic fundamentals, including the stocks and growth rates of the two monies. Direct exchanges between currencies are essential and they imply a nominal exchange rate that is different from the relative price between the two currencies in the goods markets. There are persistent violations of the law of one price and purchasing power parity in equilibrium, despite the fact that prices are perfectly flexible and all goods are tradeable between countries. Nominal and real exchange rates can move together in the steady state in response to money growth shocks.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 50 (2003)
Issue (Month): 7 (October)
Pages: 1555-1591

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Handle: RePEc:eee:moneco:v:50:y:2003:i:7:p:1555-1591

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Web page: http://www.elsevier.com/locate/inca/505566

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References

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  1. Shi Shouyong, 1997. "Search for a Monetary Propagation Mechanism," Working Papers 966, Queen's University, Department of Economics.
  2. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-60, June.
  3. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  4. Green, Edward J. & Zhou, Ruilin, 1998. "A Rudimentary Random-Matching Model with Divisible Money and Prices," Journal of Economic Theory, Elsevier, vol. 81(2), pages 252-271, August.
  5. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
  6. Shouyong Shi, 1998. "Search, Inflation, and Capital Accumulation," Working Papers 971, Queen's University, Department of Economics.
  7. Kiyotaki, Nobuhiro & Wright, Randall, 1989. "On Money as a Medium of Exchange," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 927-54, August.
  8. Shouyong Shi, 1995. "Money and Prices: A Model of Search and Bargaining," Working Papers 916, Queen's University, Department of Economics.
  9. Kiyotaki, Nobuhiro & Wright, Randall, 1993. "A Search-Theoretic Approach to Monetary Economics," American Economic Review, American Economic Association, vol. 83(1), pages 63-77, March.
  10. Kiminori Matsuyama, 1991. "Toward a Theory of International Currency," Discussion Papers 931, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  11. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
  12. Zhou, Ruilin, 1997. "Currency Exchange in a Random Search Model," Review of Economic Studies, Wiley Blackwell, vol. 64(2), pages 289-310, April.
  13. Li, Yiting & Wright, Randall, 1998. "Government Transaction Policy, Media of Exchange, and Prices," Journal of Economic Theory, Elsevier, vol. 81(2), pages 290-313, August.
  14. Obstfeld, Maurice & Rogoff, Kenneth S., 1995. "Exchange Rate Dynamics Redux," Scholarly Articles 12491026, Harvard University Department of Economics.
  15. Maurice Obstfeld, 1999. "Open-Economy Macroeconomics, Developments in Theory and Policy," NBER Working Papers 6319, National Bureau of Economic Research, Inc.
  16. Ben Craig & Christopher J. Waller, 1999. "Currency portfolios and nominal exchange rates in a dual currency search economy," Working Paper 9916, Federal Reserve Bank of Cleveland.
  17. Kareken, John & Wallace, Neil, 1981. "On the Indeterminacy of Equilibrium Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 96(2), pages 207-22, May.
  18. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  19. Manuelli, Rodolfo E & Peck, James, 1990. "Exchange Rate Volatility in an Equilibrium Asset Pricing Model," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(3), pages 559-74, August.
  20. Trejos, Alberto & Wright, Randall, 1995. "Search, Bargaining, Money, and Prices," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 118-41, February.
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