Breaking the Curse of Kareken and Wallace with Private Information

Abstract

We study the endogenous choice to accept at objects as media of exchange and their implications for nominal exchange rate determination. We consider a two-country environment with two currencies which can be used to settle any transactions. However, currencies can be counterfeited at a xed cost and the decision to counterfeit is private information. This induces equilibrium liquidity constraints on the currencies in circulation. We show that the threat of counterfeiting can pin down the nominal exchange rate even when the currencies are perfect substitutes, thus breaking the Kareken-Wallace indeterminacy result. When the two currencies are not perfect substitutes, an international currency can exist whereby one country has two currencies circulating while the other country uses only one. We also nd that with appropriate scal policies we can enlarge the set of monetary equilibria with determinate nominal exchange rates. Finally, we show that the threat of counterfeiting can also help determine nominal exchange rates in a variety of dierent trading environments.