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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Length: 34 pages Date of creation: 01 Jun 2004 Date of revision: Handle: RePEc:wdi:papers:2004-686
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Find related papers by JEL classification: C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies N20 - Economic History - - Financial Markets and Institutions - - - General, International, or Comparative O23 - Economic Development, Technological Change, and Growth - - Development Planning and Policy - - - Fiscal and Monetary Policy in Development
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Michael B. Devereux & Charles Engel & CÈdric Tille, 2003.
"Exchange Rate Pass-Through and the Welfare Effects of the Euro,"
International Economic Review,
Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 223-242, February.
[Downloadable!] (restricted)
Other versions:
Reinhart, Carmen & Calvo, Guillermo, 2002.
"Fear of floating,"
MPRA Paper
14000, University Library of Munich, Germany.
[Downloadable!]
Guillermo A. Calvo & Carmen M. Reinhart, 2000.
"Fear of Floating,"
NBER Working Papers
7993, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)