INDETERMINACY AND VOLATILITY OF EXCHANGE-RATES UNDER IMPERFECT CURRENCY SUBSTITUTION

We know that when currencies are perfect substitutes, exchange rates c ould become indeterminate. We show that even when currencies are less than perfect substitutes exchange rates could display volatility unrel ated to economic fundamentals. With increases in currency substitution : (1) the exchange rate becomes more sensitive to changes in economic fundamentals, increasing its volatility; (2) the exchange rate could b ecome indeterminate, and it is more likely to become so if governments pursue similar monetary policies; (3) currencies with high nominal in terest rates would decline significantly and the exchange rate becomes more sensitive to changes in the supply of those currencies.