UP TO THIS point, we have examined only closed monetary economies – economies that operate entirely in isolation with a single fiat money. Trade and financial links between countries are increasingly important in the modern world, raising the importance of monetary links. Therefore, in this chapter we examine the role of money in economies that encompass more than one country and currency. We examine how exchange rates are determined and seek to explain observed exchange rate changes, especially the dramatic fluctuations of recent decades. We then go on to ask what kind of international monetary system should be in place. In particular we ask the question now facing the European Community: Should trading partners agree to fix their exchange rates or, going even further, adopt a single currency?

A Model of International Exchange

To address these international issues we assume that there exist two countries, a and b, each with its own fiat money. As in Chapter 3, people live two-period lives in overlapping generations. They are endowed with goods when young but not when old, yet they want to consume in both periods of life. The endowments in each country consist of the same goods (a good in country a is indistinguishable from a good in country b). People are indifferent to the origin of the goods they purchase. We use superscripts a and b to identify the parameters and variables of each country; for example, countries a and b have population growth rates na and nb and money growth rates za and zb, respectively.