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A Fundamental Theory of Exchange Rates and Direct Currency Trades

Author

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  • Allen Head
  • Shouyong Shi

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 opportunities for instantaneous arbitrage, and hence make the nominal exchange rate determinate. The nominal exchange rate depends on the two countries 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.

Suggested Citation

  • Allen Head & Shouyong Shi, 2002. "A Fundamental Theory of Exchange Rates and Direct Currency Trades," Working Papers shouyong-03-01, University of Toronto, Department of Economics.
    • Handle: RePEc:tor:tecipa:shouyong-03-01
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    References listed on IDEAS

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    More about this item

    Keywords

    Exchange Rates; Search; Money; Currency Trade.;
    All these keywords.

    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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