Habit Persistence, Currency Competition and Sunspot Equilibria

Abstract

This paper cites the concept of consumption habit persistence and sunspot equilibria with uncertainty for analyzing the issue of currency competition to discuss the necessity of Gresham's Law and provide a complement of explanation to the euro exchange rate movements. We study the economy in one-good, two-currency Brock model with perfect currency substitution in discrete time. With habit persistence, we show that the optimal holding of currency asset is affected by the elasticity of intertemporal substitution. Besides, the higher-growth-rate currency does not always dominate the other currency in the long run. The Gresham-law result obtained in the deterministic model could not be true in a stationary sunspot equilibrium with a first-order Markov extrinsic uncertainty process. The existence of sunspot equilibria expresses another situation of currency competition depending on the possibility of people's expectations and supports complementally the investor-emotion view of the empirical studies in the currency-asset holding and the euro exchange rate movements.