Strong currency and weak currency

This paper presents a two-country model in which two currencies compete wit h each other. There exists an equilibrium in which the two currencies with different rates of inflation circulate as media of exchange despite neither currency being required to be used for transactions. Taxes payable in loca l currency and asymmetric injection of fiat money by the government through purchases of a certain good generate demands even for the currency with a higher inflation rate. In such an equilibrium, the government that issues t he currency with a lower rate of inflation collects seigniorage not only fr om its own residents but from the residents of the other country provided t hat the rate of inflation is positive. The strong currency in the sense of a low inflation rate becomes an international medium of exchange. Policy ga mes, in which the two governments simultaneously choose and commit to tax r ates and inflation rates, are also examined. We show, among other things, t hat the equilibrium rate of inflation is zero in this policy game. In other words, unlike a common argument, the rate of inflation does not go below z ero. This result is due to the fact that a negative rate of inflation induc es a negative amount of seigniorage and vice versa. Some alternative curren cy regimes are examined. Even for a country with a weak currency, abandonme nt of its currency leads to a lower level of welfare. Monetary unions are b riefly discussed as well. (C) 1998 Academic Press.