Imperfect asset substitution in a two-country model

Abstract

The paper reports results obtained from the simulation of a two-country model in which the real and financial sectors are integrated under an assumption of rational expectations and steady state inflationary equilibria. The government of each country issues a single financial asset (‘currency’) which is held by the government of the other country and by the private residents of both countries. The model is simulated under a variety of shocks and the effects of higher currency substitution (measured in different ways) are explored. The results show that, depending on the shock hitting the system and the way in which the degree of currency substitution is measured, higher levels of currency substitution may reduce instead of increasing the degree of exchange rate overshooting and may even convert overshooting into undershooting. The paper lays a basis for various extensions which will be reported in subsequent papers.