TY - JOUR
T1 - A fundamental theory of exchange rates and direct currency trades
AU - Head, Allen
AU - Shi, Shouyong
N1 - Funding Information:
This paper is the result of numerous revisions of a previous paper circulated under the title “Search, Inflation, and Exchange Rates”: ( Head and Shi, 1996 ). We have received valuable comments from Ruilin Zhou, Neil Wallace, Chris Waller, Alan Stockman, Gregor Smith, Maurice Obstfeld, George Mailath, Beverly Lapham, Narayana Kocherlakota, Gabriele Camera, and the participants of workshops and conferences at Rochester, Queen's, Purdue, Pennsylvania, Kentucky, Indiana, UQAM, Waterloo, York, Northwestern University summer macro workshop (1997), Econometric Society summer meeting (1997), Canadian macro study group meeting (1998), and Texas Monetary Conference (2001). Both authors gratefully acknowledge the financial support from the Social Sciences and Humanities Research Council of Canada. All errors are ours alone.
PY - 2003/10
Y1 - 2003/10
N2 - 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.
AB - 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.
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U2 - 10.1016/j.jmoneco.2003.08.004
DO - 10.1016/j.jmoneco.2003.08.004
M3 - Article
AN - SCOPUS:0142118658
SN - 0304-3932
VL - 50
SP - 1555
EP - 1591
JO - Carnegie-Rochester Confer. Series on Public Policy
JF - Carnegie-Rochester Confer. Series on Public Policy
IS - 7
ER -