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Rational Expectations, Endogenous Currency Substitution, and Exchange Rate Determination

Harvey E. Lapan; Walter Enders

Iowa State University

The paper employs the intergenerational model to derive the demands for domestic and foreign currencies from microeconomic optimizing behavior. In the absence of government policy, we obtain the Kareken and Wallace result that exchange rates are constant and indeterminate. We discuss the reasons why nations may find it in their interests to impose probabilistic capital controls. It is shown that the imposition of probabilistic capital controls yields a unique (generally nonstationary) exchange rate path and that this path is determined in accord with the Monetary Approach. As the probability of controls tends to zero, the exchange rate remains determinate.

DOI

10.2307/1886019

Volume

98 (3)

Pages

427

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