In this equilibrium, the foreign currency also trades at a discount in the domestic market. Foreign agents are not allowed to acquire from domestic government agents with any currency. This creates a bias for domestic citizens to use the domestic currency, which again leads to currency exchange between citizens of different countries holding the currencies opposite their national identities. A .pdf file. We develop a dual currency search model to study equilibrium currency exchange and the determination of nominal exchange rates.
Agents hold portfolios consisting of two distinct currencies.
We study equilibria in which the two currencies are identical and equilibria in which the two currencies differ according to their relative purchasing power risk. We use numerical methods to solve for the steady-state distributions of currency portfolios, nominal exchange rates and value functions. When one of the currencies is 'risky', equilibria exist in which the safe currency trades for multiple units of the risky currency with the observed ratio being the nominal exchange rate. However, due to the decentralized trading environment, we obtain a steady state distribution of nominal exchange rates. The mean and variance of the nominal exchange rate distribution are based on the fundamentals of the model and change in predictable ways when the fundamentals change.