ABSTRACT
The purpose of the model developed in this chapter is to investigate the behavior of prices, interest rates and exchange rates in a world with seasonal fluctuations in output, fixed money stocks and flexible exchange rates. As discussed in the review of the literature in the last chapter, seasonal fluctuations of short term nominal interest rates and seasonal fluctuations of exchange rates within the gold points were features of the pre-World War I gold standard. The model developed here is designed to address the issue of whether or not seasonal fluctuations of output can generate seasonal fluctuations of interest rates and exchange rates in an equilibrium, optimizing world with no transactions costs. The model is a two country, flexible exchange rate, cash-in-advance, optimizing model with foreign bonds and two currencies as the only tradable assets. Exchange rates were not, of course, completely flexible during the gold standard because exchange rate fluctuations were limited by the gold points. Given that the interest of this study is on fluctuations of exchange rates within the gold points, a flexible exchange rate model is more appropriate than a
The model developed here is well suited to investigating the implications of changing conventions regarding which currency is used to conduct international trade. Kimbrough (1986) points out the importance of these conventions for goods market arbitrage conditions. During the heyday of the gold standard, most international trade was conducted using sterling exchange. In other historical periods, other invoicing conventions have been widely practiced. 1 This study does not investigate why a particular invoicing convention is adopted, but rather explores the time series behavior of the exchange rate, interest rates and prices under different specifications for the finance of international trade. The objective here is to determine whether the way in which trade is financed matters for the time series behavior of interest rates and exchange rates in a two country world with seasonal endowment fluctuations, fixed money stocks and flexible exchange rates.
