Multiple currencies and sunspots exchange rates in a stochastic economy

Abstract

Risk averse agents may be willing to hold two currencies even if they yield different rates of return. In a stochastic economy, agents care about the expected marginal utility of holding each currency rather than simple rates of return. Therefore, currency substitution in terms of rates of return may not occur. In this environment, this paper shows that exchange rates are more volatile than the monetary theory of exchange rate dictates. Velocities are not constant in this economy and add extra volatility to exchange rate fluctuations. Finally, we suggest that sunspots may be important source of the rate volatility.