A Fundamental Theory of Exchange Rates and Direct Currency Trades
AbstractIn this paper we construct a two-country search monetary model to determine the nominal exchange rate between two fiat monies. Our model imposes natural restrictions on agents' opportunities for arbitrage. These restrictions bind when the gross growth rates of the two currency stocks exceed the discount factor. In this case the nominal exchange rate is determinate and depends on economic fundamentals of the two countries' economies, including the stocks and growth rates of the two monies. The model generates essential, direct currency-for-currency exchanges, which imply a nominal exchange rate that is different from the relative price between the two currencies in the goods markets. Unless the stocks of the two monies remain constant, 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 InfoPaper provided by Queen's University, Department of Economics in its series Working Papers with number 993.
Date of creation: Jul 2000
Date of revision:
Exchange Rates; Search; Currency Trade; Money;
Other versions of this item:
- Head, Allen & Shi, Shouyong, 2003. "A fundamental theory of exchange rates and direct currency trades," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1555-1591, October.
- Allen Head & Shouyong Shi, 2002. "A Fundamental Theory of Exchange Rates and Direct Currency Trades," Working Papers shouyong-03-01, University of Toronto, Department of Economics.
- F31 - International Economics - - International Finance - - - Foreign Exchange
- C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
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