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Currency Substitution and the Law of One Price
Feb 7, 2001
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| Abstract: We study endogenous currency substitution and price formation in a general equilibrium model with bilateral and decentralized international trade. Sellers of homogenous goods choose to post prices in either of two currencies given that buyers' valuation is unobservable. We show that the absence of well integrated international goods markets doesn't necessarily imply a violation of the law of one price. In equilibrium goods may be priced only in the local currency, but scarcity of local liquidity supports equilibria with currency substitution where the law of one price holds. By fostering trade, international circulation of money may enhance welfare. |
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