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Instability in Exchange Rates of the World Leading Currencies: Implications of a Spatial Competition Model among Central Banks

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Author Info

  • Dirk Engelmann

    ()

  • Jan Hanousek

    ()

  • Evžen Kocenda

    ()

Abstract

We use a spatial competition based model in a two-stage game setup to assess whether equilibrium in exchange rates among the leading currencies is attainable. We show that a stable equilibrium can be reached in the case of two leading currencies, but not in the case of three. In our model, central banks of leading currencies attract, through the workings of their objective and policy, small currencies that tie with leading currencies via exchange rate regimes. This can be thought of as a competition to link smaller currencies to a leading currency that is motivated by the fact that such a tie greatly reduces volatility within such an informal “currency area”. Our theoretical findings are supported by empirical evidence. Since firms, traders, and countries currently recognize three leading currencies and their economic behavior reflects this, we may expect disagreement on overvaluation or undervaluation of certain currencies to continue.

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Bibliographic Info

Paper provided by William Davidson Institute at the University of Michigan in its series William Davidson Institute Working Papers Series with number 2004-686.

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Length: 34 pages
Date of creation: 01 Jun 2004
Date of revision:
Handle: RePEc:wdi:papers:2004-686

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Keywords: exchange rates; exchange rate regimes; central bank policy; monetary union; spatial competition;

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  1. Ernesto H. Stein & Natalia Salazar & Roberto Steiner & Eugenio Díaz-Bonilla & Marco Bonomo & Juan C. Jaramillo & Hector E. Schamis & Alberto Pascó-Front & Piero Ghezzi & Maria Cristina Terra & José, . "The Currency Game: Exchange Rate Politics in Latin America," IDB Publications 77398, Inter-American Development Bank.
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  8. B.Curtis Eaton & Richard G. Lipsey, 1972. "The Principle of Minimum Differentiation Reconsidered: Some New Developments in the Theory of Spatial Competition," Working Papers 87, Queen's University, Department of Economics.
  9. Battilossi, Stefano & Cassis, Youssef (ed.), 2002. "European Banks and the American Challenge: Competition and Cooperation in International Banking Under Bretton Woods," OUP Catalogue, Oxford University Press, number 9780199250271.
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  11. Hess, Gregory D. & Porter, Richard D., 1993. "Comparing interest-rate spreads and money growth as predictors of output growth: Granger causality in the sense Granger intended," Journal of Economics and Business, Elsevier, vol. 45(3-4), pages 247-268.
  12. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
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  14. Benassy-Quere, AgnEs & Fontagne, Lionel & LahrEche-Revil, Amina, 2001. "Exchange-Rate Strategies in the Competition for Attracting Foreign Direct Investment," Journal of the Japanese and International Economies, Elsevier, vol. 15(2), pages 178-198, June.
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