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A Fundamental Theory of Exchange Rates and Direct Currency Trades

  • Allen Head


    (Queen's University)

  • Shouyong Shi

    (Queen's University)

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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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
Date of revision:
Handle: RePEc:qed:wpaper:993
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  1. 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.
  2. 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.
  3. Maurice Obstfeld, 1999. "Open-Economy Macroeconomics, Developments in Theory and Policy," NBER Working Papers 6319, National Bureau of Economic Research, Inc.
  4. Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
  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.
  6. Shi, Shouyong, 1998. "Search for a Monetary Propagation Mechanism," Journal of Economic Theory, Elsevier, vol. 81(2), pages 314-352, August.
  7. Shouyong Shi, 1997. "A Divisible Search Model of Fiat Money," Econometrica, Econometric Society, vol. 65(1), pages 75-102, January.
  8. 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.
  9. Shouyong Shi, 1995. "Money and Prices: A Model of Search and Bargaining," Working Papers 916, Queen's University, Department of Economics.
  10. Shouyong Shi, 1998. "Search, Inflation, and Capital Accumulation," Working Papers 971, Queen's University, Department of Economics.
  11. 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.
  12. 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.
  13. 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.
  14. Edward J. Green & Ruilin Zhou, 1996. "A Rudimentary Random-Matching Model with Divisible Money and Prices," GE, Growth, Math methods 9606001, EconWPA, revised 25 Jul 1996.
  15. Matsuyama, Kiminori & Kiyotaki, Nobuhiro & Matsui, Akihiko, 1993. "Toward a Theory of International Currency," Review of Economic Studies, Wiley Blackwell, vol. 60(2), pages 283-307, April.
  16. Zhou, Ruilin, 1997. "Currency Exchange in a Random Search Model," Review of Economic Studies, Wiley Blackwell, vol. 64(2), pages 289-310, April.
  17. 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.
  18. 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.
  19. 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.
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