Abstract
Although China, now the world’s second largest economy and largest goods trading nation, has rolled out the ambitious currency internationalization protocol while maintaining strict capital controls for nearly a decade, the implications of this unique reform path on the international economy still present uncertainties. In this paper, we fill in this gap by developing a two country, two-goods model to investigate the impacts of currency internationalization on the international price system, which consists of goods market and factor market interactions. We propose a critical condition of sustainable currency internationalization and reveal high international price sensitivity to exchange rate adjustments.
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Notes
In reality, this can also be reflected by the reduction of the liquidity premium of the RMB in the offshore
market over the RMB in the onshore market (Cheung and Rime 2014).
When there exists home bias in consumption functions, the real exchange rate will face similar lower and upper bounds, though of different values. For example, if the two goods are substitutes (ϕ > 1) and the two countries share the same home bias, then the constraint of the real exchange rate can be written as: \( \left(1-\theta \right){\left(\frac{a}{1-a}\right)}^{1/\left(1-\phi \right)}<\varepsilon <{\left(\frac{a}{1-a}\right)}^{1/\left(1-\phi \right)} \), where a > 0.5 represents the home bias.
For C-D consumption function (ϕ = 1), the limit does not exist: \( \underset{\phi \to {1}^{-}}{\lim }=\infty \) while \( \underset{\phi \to {1}^{+}}{\lim }=0 \).
In simulation, the literature usually sets gross elasticity of substitution slightly above unity (e.g., Backus et al. 1994; Heathcote and Perri 2002; Engel and Matsumoto 2009). Nonetheless, Feenstra et al. (2012) estimate that the gross elasticity is not significantly different from one. Thus, we use four values of ϕ in the simulation: 0.7, 0.9, 1.1, and 1.3.
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Jin, H., Takumah, W. & Jorenby, J. Currency Internationalization and the International Price System. Int Adv Econ Res 24, 303–309 (2018). https://doi.org/10.1007/s11294-018-9711-y
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DOI: https://doi.org/10.1007/s11294-018-9711-y