Search-theoretic Money, Capital and Exchange Rate Fluctuationsf

We explore how the underlying informational frictions, or anonymity, that give rise to the existence of monetary exchange affect international exchange rate dynamics. Using a two-country, two-sector model, we show that information friction implies a particular restriction on domestic relative pricing 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, there is a further restriction on asset pricing relations (money and capital), as result of monetary and real outcomes being interdependent in the model. Our perfectly flexible price model is capable of producing seemingly rigid aggregate prices, endogenously, in response to technology and monetary shocks. The model is thus 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. These quantitative features are obtained with the model also being consistent with other standard real business cycle facts. JEL CODES: E31; E32; E43; E44