Breaking the Kareken and Wallace Indeterminacy Result

Timothy Kam, Pedro Gomis-Porqueras and Christopher Waller

ANU Working Papers in Economics and Econometrics from Australian National University, College of Business and Economics, School of Economics

Abstract: In this paper we study the endogenous choice to accept fiat objects as media of exchange, the fundamentals that drive their acceptance, and their implications for their bilateral nominal exchange rate. To this end, we consider a small open economy where agents have no restrictions on what divisible fiat currency can be used to settle transactions (i.e. no currency control). We build on Li, Rocheteau and Weill (2013) and allow both fiat currencies to be counterfeited at some fixed costs. The two currencies can coexist, even if one of the currencies is dominated by the other in rate of return. This is driven by an equilibrium outcome in which private information and threats of counterfeiting imposes an equilibrium liquidity constraint on currencies in circulation. Thus, threats of counterfeiting help to pin down a determinate nominal exchange rate, and, to break the Kareken-Wallace indeterminacy result in an environment without ad-hoc currency controls. Finally, we show that with appropriate fiscal policies we can enlarge the set of monetary equilibria with determinate nominal exchange rate.

Pages: 33 pages
Date: 2013-11
New Economics Papers: this item is included in nep-mac, nep-mon and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:acb:cbeeco:2013-613

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