A model of international currency with private information

Abstract

This paper studies a model in which nominal exchange rate is determined by asymmetric information. Within a two-country two-currency search-theoretic model, buyers have complete information, while sellers have incomplete information regarding the real value of foreign currencies in decentralized meetings. With no restrictions on which currency to use to settle transactions, sellers’ domestic currency turns out to be the preferred means of payment in equilibrium and various currency regimes emerge endogenously. The degree of information asymmetry and economic openness have ambiguous impacts on the nominal exchange rate due to the variety of currency regimes. When two countries interact in a policy game of setting inflation targets, the equilibrium inflation targets also depend on the degree of information asymmetry and economic openness, since these factors affect the seigniorage revenue and accordingly central banks’ temptation to inflate.