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

  • Dirk Engelmann

    ()

  • Jan Hanousek

    ()

  • Evžen Kocenda

    ()

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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File URL: http://www.wdi.umich.edu/files/Publications/WorkingPapers/wp686.pdf
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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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