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

Dirk Engelmann, Jan Hanousek and Evžen Kočenda

William Davidson Institute Working Papers Series from William Davidson Institute at the University of Michigan

Abstract: 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.

Keywords: exchange rates; exchange rate regimes; central bank policy; monetary union; spatial competition (search for similar items in EconPapers)
JEL-codes: C72 E42 E58 N20 O23 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2004-06-01
New Economics Papers: this item is included in nep-afr, nep-ifn and nep-mac
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Related works:
Journal Article: Currencies, competition, and clans (2008)
Working Paper: Instability in Exchange Rates of the World Leading Currencies: Implications of a Spatial Competition Model among Central Banks (Currencies, Competition, and Clans) (2004)
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