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A Fundamental Theory of Exchange Rates and Direct Currency Trades

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Author Info
Allen Head
Shouyong Shi

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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<92> opportunities for instantaneous arbitrage, and hence make the nominal exchange rate determinate. The nominal exchange rate depends on the two countries<92> 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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Publisher Info
Paper provided by University of Toronto, Department of Economics in its series Working Papers with number shouyong-03-01.

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Length: 49 pages
Date of creation: 15 Dec 2002
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Handle: RePEc:tor:tecipa:shouyong-03-01

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Related research
Keywords: Exchange Rates; Search; Money; Currency Trade.;

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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

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  1. Canadian Macro Study Group
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. 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)
  2. 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)
  3. 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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  4. 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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  5. 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)
  6. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-60, June. [Downloadable!] (restricted)
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  7. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
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  8. Shouyong Shi, 1995. "Money and Prices: A Model of Search and Bargaining," Working Papers 916, Queen's University, Department of Economics.
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  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. [Downloadable!] (restricted)
  10. 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)
  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. [Downloadable!] (restricted)
  12. 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)
  13. 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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  14. 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)
  15. 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)
  16. 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)
  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. Stephen D. Williamson, 2009. "Transactions, Credit, and Central Banking in a Model of Segmented Markets," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(2), pages 344-362, April. [Downloadable!] (restricted)
  2. John Duffy & Maxim Nikitin, 2004. "Dollarization Traps," Econometric Society 2004 North American Summer Meetings 456, Econometric Society. [Downloadable!]
    Other versions:
  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!]
    Other versions:
  4. Michael B. Devereux & Shouyong Shi, 2008. "Vehicle Currency," Working Papers tecipa-315, University of Toronto, Department of Economics. [Downloadable!]
    Other versions:
  5. Shouyong Shi, 2006. "A Microfoundation of Monetary Economics," Working Papers tecipa-211, University of Toronto, Department of Economics. [Downloadable!]
  6. Ed Nosal & Guillaume Rocheteau, 2006. "The economics of payments," Policy Discussion Papers, Federal Reserve Bank of Cleveland, issue Feb. [Downloadable!]
  7. 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!]
    Other versions:
  8. Alok Kumar, 2004. "Inflation and the Dispersion of Real Wages," Econometric Society 2004 Far Eastern Meetings 750, Econometric Society. [Downloadable!]
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  9. Qing Liu & Shouyong Shi, 2006. "Currency Areas and Monetary Coordination," Working Papers tecipa-226, University of Toronto, Department of Economics. [Downloadable!]
    Other versions:
  10. Zhu, Tao, 2007. "Equilibrium Concepts in the Large Household Model," MPRA Paper 7444, University Library of Munich, Germany. [Downloadable!]
    Other versions:
  11. Flandreau, Marc & Jobst, Clemens, 2006. "The Empirics of International Currencies: Historical Evidence," CEPR Discussion Papers 5529, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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