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A Fundamental Theory of Exchange Rates and Direct Currency Trades

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Author Info
Allen Head () (Queen's University)
Shouyong Shi (Queen's University)

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Abstract

In 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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Publisher Info
Paper provided by Queen's University, Department of Economics in its series Working Papers with number 993.

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Date of creation: Jul 2000
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Handle: RePEc:qed:wpaper:993

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Related research
Keywords: Exchange Rates Search Currency Trade Money

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. 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. [Downloadable!] (restricted)
  2. Zhou, Ruilin, 1997. "Currency Exchange in a Random Search Model," Review of Economic Studies, Blackwell Publishing, vol. 64(2), pages 289-310, April. [Downloadable!] (restricted)
  3. 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. [Downloadable!] (restricted)
  4. Shi, Shouyong, 1998. "Search for a Monetary Propagation Mechanism," Journal of Economic Theory, Elsevier, vol. 81(2), pages 314-352, August. [Downloadable!] (restricted)
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  5. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  6. Obstfeld, Maurice, 1998. " Open-Economy Macroeconomics: Developments in Theory and Policy," Scandinavian Journal of Economics, Blackwell Publishing, vol. 100(1), pages 247-75, March. [Downloadable!] (restricted)
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  7. 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. [Downloadable!] (restricted)
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  8. 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. [Downloadable!] (restricted)
  9. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
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  10. Shi Shougong, 1995. "Money and Prices: A Model of Search and Bargaining," Journal of Economic Theory, Elsevier, vol. 67(2), pages 467-496, December. [Downloadable!] (restricted)
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  11. 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. [Downloadable!] (restricted)
  12. 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. [Downloadable!] (restricted)
  13. 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. [Downloadable!] (restricted)
  14. 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. [Downloadable!] (restricted)
  15. 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. [Downloadable!] (restricted)
  16. 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. [Downloadable!] (restricted)
  17. 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. [Downloadable!]
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. John Duffy & Maxim Nikitin, 2004. "Dollarization Traps," Econometric Society 2004 North American Summer Meetings 456, Econometric Society. [Downloadable!]
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  2. Aleksander Berentsen & Guillaume Rocheteau & Shouyong Shi, 2002. "Friedman Meets Hosios: Efficiency in Search Models of Money," Working Papers shouyong-02-04, University of Toronto, Department of Economics. [Downloadable!]
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  3. Gabriele Camera & Ben Craig & Christopher J. Waller, 2003. "Currency competition in a fundamental model of money," Working Paper 0311, Federal Reserve Bank of Cleveland. [Downloadable!]
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  4. Alok Kumar, 2004. "Inflation and the Dispersion of Real Wages," Econometric Society 2004 Far Eastern Meetings 750, Econometric Society. [Downloadable!]
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  5. Michael B. Devereux & Shouyong Shi, 2008. "Vehicle currency," Globalization and Monetary Policy Institute Working Paper 10, Federal Reserve Bank of Dallas. [Downloadable!]
    Other versions:
    • Michael B. Devereux & Shouyong Shi, 2008. "Vehicle Currency," Working Papers tecipa-315, University of Toronto, Department of Economics. [Downloadable!]
  6. Qing Liu & Shouyong Shi, 2006. "Currency Areas and Monetary Coordination," Working Papers tecipa-226, University of Toronto, Department of Economics. [Downloadable!]
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  7. Zhu, Tao, 2007. "Equilibrium Concepts in the Large Household Model," MPRA Paper 7444, University Library of Munich, Germany. [Downloadable!]
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  8. Flandreau, Marc & Jobst, Clemens, 2006. "The Empirics of International Currencies: Historical Evidence," CEPR Discussion Papers 5529, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  9. Shouyong Shi, 2006. "A Microfoundation of Monetary Economics," Working Papers tecipa-211, University of Toronto, Department of Economics. [Downloadable!]
  10. Ed Nosal & Guillaume Rocheteau, 2006. "The economics of payments," Policy Discussion Papers, Federal Reserve Bank of Cleveland, issue Feb. [Downloadable!]
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