Exchange Rates When Financial Markets Are Imperfect

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

We know that financial markets play an important role in determining exchange rates between different national currencies. This award funds research to develop a new model of how financial markets affect exchange rates. In the real world, financial markets do not always fit into the framework of perfect competition. One major reason why financial markets are imperfect is that financiers have a limited ability to bear risks. The researchers will build and analyze a model of global capital flows that includes global financiers as the intermediaries for capital flows between countries. The research team will develop predictions from this model and then test the predictions against data. They will also explore policy implications, especially policies for periods of dysfunctional financial markets. The project provides a full general equilibrium model of exchange rates in the presence of imperfect financial markets. The team starts with a basic theory of exchange rate financial determination in a two-period two-country model where capital flows are intermediated by financiers. Exchange rates are jointly determined by capital flows and financiers' capacity to bear currency risk. They then expand this framework to a richer model that combines financial forces such as risk taking and financial intermediation in imperfect capital markets with the traditional real economy analysis of production, import and export.