Money, Capital And Exchange Rate Fluctuations

We explore how the informational frictions underlying monetary exchange affect international exchange rate dynamics. Using a two-country, two-sector model, we show that information frictions imply a particular restriction on domestic price dynamics and hence on international nominal and real exchange rate determination. Furthermore, if capital is utilized as a factor of production in both production sectors, then there is a further restriction on asset pricing relations (money and capital). As a result, monetary and real outcomes become interdependent in the model. Our perfectly flexible price model is capable of producing endogenously rigid international relative prices in response to technology and monetary shocks. The model is capable of accounting for the empirical regularities that the real and nominal exchange rates are more volatile than U.S. output, and that the two are positively and perfectly correlated. The model is also consistent with other standard real business cycle facts for the U.S.