Exchange Rate Determination: A Model of the Decisive Role of Central Bank Cooperation and Conflict

Opinion is divided on whether it is better to have a single world   money or variable exchange rates.  Pope, Selten and von Hagen (2003)   propose that fresh light would be shed via an analysis that allows   for seven complexity impacts on the exchange rate that are   underplayed (where not entirely absent) from current analyses: 1) the   role of official sector, including its central bank; 2) the numerous   official and private sector goals; 3) the disparate degrees of market   power of different sorts of private agents; 4) the documentation that   essentially all shocks to the exchange rate are generated by human   decisions; 5) the non-maximising heuristics that in the complex   economy agents use; 6) heterogenous beliefs.  This paper analyses a   closed form game theoretic solution of version 1 of a model that   combines impacts 1 to 4 with the conventional finance assumption that   all agents maximise their utility.  Impact 1) precludes private   agents being able to destabilise the exchange rate against the   cooperation of the central banks required by the game theoretic   solution.  Impact 4) excludes random events and other exogenous   shocks such as meteors falling from the sky.  The rational maximising   assumption in turn precludes all other sources of shocks and thus any   need for a variable exchange rate to equilibrate after shocks.  We   then modify version 1 of our model substituting for the maximising   assumption impacts 5 to 7, impacts that allow shocks from humans to   be consistently incorporated.  We do so by means of an experimental   investigation which indicates that central bankers less than fully   cooperate, leaving scope for private speculators to support their   preferred currency.  From the viewpoint of the game theoretic   equilibrium, the resultant exchange rate changes render equilibrium   unspecified.  A single world money avoids disruptive exchange rate   changes from less than fully cooperating central banks, exchange rate   changes caused by central bank conflicts and that cannot be   classified as equilibrating.