lOMoAR cPSD| 45211451
CHAP 5 Modeling Monetary
Economies 4th Edition
MONEY AND BANKING
, lOMoAR cPSD| 45211451
Chapter 5
International Monetary Systems
1 Roadmap
We continue on the theme of governmentand money in
this chapter. Instead of having only one governmentat a time,
however, we move on to consider a world in which each
governmenthas its own monetary policy. Indeed, the main
piece added in this chapter is to examine the question:
What happens when each country issues its own fiat money? The
organizing principle is that there is a price at which each
currency trades for another country’s currency. In other words,
the exchange rate is the rate at which one country’s currency
is traded for another country’s currency. In this
international monetary currency, we consider a basic friction; each
country requires its young people to hold its home country’s
money. From here, we can determine what the exchange rate will
be when there is a single consumption good and the Law of
One Price holds.In addition, we can see the effects of different
monetary policies and different economic growth rates on the
equilibrium exchange rate.
In the second part of this chapter, we get rid of the
friction and allow young people to hold any kind of
currency they want. In doing so, we face a new economic
outcome; namely, what happens when the equilibrium exchange rate is
indeterminate. Now there is a coordination game between
governments that sets the exchange rate. If these agreements are
fragile, the exchange rate becomes more volatile. We describe
two means of defending a particular exchange rate. In one
defense, the two governments work together while in other
defense, a country works alone.
, lOMoAR cPSD| 45211451
One last note to make.This is the first time we look at
an economy in which there is at least two storesof value coexisting.
Up to this point, we have examined only closed monetary
economies; that is, economies that operate entirely in isolation
with a single fiat money. Trade and financial links between
countries are increasingly important in the modern world, raising
the importance of monetary links. Therefore, in this chapter we
examine the role of money in economies that encompass
more than one country and currency. We examine how exchange
rates are determined and seek to explain observed exchange rate
changes, especially the dramatic fluctuations of recent decades.
We then go on to ask what kind of international monetary
system should be in place. In particular, we ask the
question addressed by the European Economic Community: Should
trading partners agree to fix their exchange rates or, going even
further, adopt a single currency?
2 A Model of International Exchange
To address these international issues, we assume that
there exist two countries, a and b, each with its own fiat
money. As in Chapter 3, people live two-period lives in
overlapping generations. They are endowed with goods when young
but not when old, yet they want to consume in both periods
of life. The endowments in each country consist of the
same goods (a good in country a is indistinguishable from a
good in country b). People are indifferent to the origin of the
goods they purchase. We use superscripts a and b to identify
the parameters and variables of each country; for example,
countries a and b have population growth rates and
and money growth rates and , respectively. Assume that
all changes in the fiat money stock are used to purchase
goods for the government. We assume there is free
international trade in goods.
Themonies of the two countries can be traded at the
“exchange rate” , which is defined as the units of country b
, lOMoAR cPSD| 45211451
money that can be purchased with one unit of country a
money.
For example, suppose country a is the United Statesand
country b is Japan. Then the exchange rate is
the number of Japanese yen per U.S. dollar or, alternatively,
the number of yen that can be bought with a dollar.
(There is, of course, a second exchange rate, the
number of U.S. dollars that can be bought with a
Japanese yen, which is simply the inverse of the first
exchange rate. It does not matter which one we study.)
As in our single-country model, old people seek to
trade their fiat money for the goods owned by young
people. Naturally, the old people wish to purchase the most
goods possible with the money they have. By definition, the
owner of a unit of country a money at time can
buy goods, and the owner of a unit of country
b money at time can buy goods. If people
are free to trade monies at the exchange rate , then the
owner of a unit of country a money has the
option of purchasing goods with country a money or
trading a unit of country a money for units of
country b money, which will buy goods. Similarly, an
owner of a unit of country b money has the option
of purchasing goods with country b money or trading
a unit of country b
money for units of country a money, which will buy
goods. These options are depicted in Table 5.1.
Table 5.1. An old person born in country (the
upper panel) has two options regarding what to do with
CHAP 5 Modeling Monetary
Economies 4th Edition
MONEY AND BANKING
, lOMoAR cPSD| 45211451
Chapter 5
International Monetary Systems
1 Roadmap
We continue on the theme of governmentand money in
this chapter. Instead of having only one governmentat a time,
however, we move on to consider a world in which each
governmenthas its own monetary policy. Indeed, the main
piece added in this chapter is to examine the question:
What happens when each country issues its own fiat money? The
organizing principle is that there is a price at which each
currency trades for another country’s currency. In other words,
the exchange rate is the rate at which one country’s currency
is traded for another country’s currency. In this
international monetary currency, we consider a basic friction; each
country requires its young people to hold its home country’s
money. From here, we can determine what the exchange rate will
be when there is a single consumption good and the Law of
One Price holds.In addition, we can see the effects of different
monetary policies and different economic growth rates on the
equilibrium exchange rate.
In the second part of this chapter, we get rid of the
friction and allow young people to hold any kind of
currency they want. In doing so, we face a new economic
outcome; namely, what happens when the equilibrium exchange rate is
indeterminate. Now there is a coordination game between
governments that sets the exchange rate. If these agreements are
fragile, the exchange rate becomes more volatile. We describe
two means of defending a particular exchange rate. In one
defense, the two governments work together while in other
defense, a country works alone.
, lOMoAR cPSD| 45211451
One last note to make.This is the first time we look at
an economy in which there is at least two storesof value coexisting.
Up to this point, we have examined only closed monetary
economies; that is, economies that operate entirely in isolation
with a single fiat money. Trade and financial links between
countries are increasingly important in the modern world, raising
the importance of monetary links. Therefore, in this chapter we
examine the role of money in economies that encompass
more than one country and currency. We examine how exchange
rates are determined and seek to explain observed exchange rate
changes, especially the dramatic fluctuations of recent decades.
We then go on to ask what kind of international monetary
system should be in place. In particular, we ask the
question addressed by the European Economic Community: Should
trading partners agree to fix their exchange rates or, going even
further, adopt a single currency?
2 A Model of International Exchange
To address these international issues, we assume that
there exist two countries, a and b, each with its own fiat
money. As in Chapter 3, people live two-period lives in
overlapping generations. They are endowed with goods when young
but not when old, yet they want to consume in both periods
of life. The endowments in each country consist of the
same goods (a good in country a is indistinguishable from a
good in country b). People are indifferent to the origin of the
goods they purchase. We use superscripts a and b to identify
the parameters and variables of each country; for example,
countries a and b have population growth rates and
and money growth rates and , respectively. Assume that
all changes in the fiat money stock are used to purchase
goods for the government. We assume there is free
international trade in goods.
Themonies of the two countries can be traded at the
“exchange rate” , which is defined as the units of country b
, lOMoAR cPSD| 45211451
money that can be purchased with one unit of country a
money.
For example, suppose country a is the United Statesand
country b is Japan. Then the exchange rate is
the number of Japanese yen per U.S. dollar or, alternatively,
the number of yen that can be bought with a dollar.
(There is, of course, a second exchange rate, the
number of U.S. dollars that can be bought with a
Japanese yen, which is simply the inverse of the first
exchange rate. It does not matter which one we study.)
As in our single-country model, old people seek to
trade their fiat money for the goods owned by young
people. Naturally, the old people wish to purchase the most
goods possible with the money they have. By definition, the
owner of a unit of country a money at time can
buy goods, and the owner of a unit of country
b money at time can buy goods. If people
are free to trade monies at the exchange rate , then the
owner of a unit of country a money has the
option of purchasing goods with country a money or
trading a unit of country a money for units of
country b money, which will buy goods. Similarly, an
owner of a unit of country b money has the option
of purchasing goods with country b money or trading
a unit of country b
money for units of country a money, which will buy
goods. These options are depicted in Table 5.1.
Table 5.1. An old person born in country (the
upper panel) has two options regarding what to do with
