Search-based models of money in dual currency economies

A particularly acute problem that plagues both developing and transitional economies is the maintenance of a stable domestic currency. In such economies, a foreign, internationally reputable currency often circulates along side the domestic currency. Although the use of a foreign currency in domestic retail transactions is prohibited by law in many of these economies, it is often held and used as an alternative medium of exchange. The potential internal problems associated with domestic currency instability in 'dollarized' economies is the motivating factor for this research.; A fixed-price search theory model is constructed to capture the relationship between a domestic 'legal' currency and a foreign 'illegal' currency in a transitional or developing economy. The model shows how the circulation of two currencies will affect the equilibrium trades when the acceptabilities of the currencies vary. Mixed and pure monetary equilibria exist. I solve for the expected black market exchange rate and show how government policies can affect the acceptability of the currencies and the rate of exchange. The model is then extended to allow bargaining between agents with homogeneous preferences in order to derive nominal prices, the risk premium on illegal currency and exchange rates. Multiple monetary equilibria exist but mixed-monetary or partial acceptability equilibria do not. The results from Nash bargaining show that the values of the two currencies are interdependent, suggesting that currency 'competition' and currency 'substitution' are important processes in determining the equilibrium values of the currencies. Finally, the model is modified to allow bargaining between agents with heterogeneous preferences. In this model, there is a motivation for currency exchange. Equilibria are re-generated where the illegal currency circulates with partial or full acceptability and where again the equilibria exhibit currency interdependence. It is shown that increasing the acceptability of illegal money in trade can be welfare improving, assuming that legal money is fully acceptable and that the transactions costs of both currencies are quite high.; The results of this thesis suggest that governments in dual currency economies should take into consideration currency interdependence in their formation of stabilization policies. In addition, these models may have important implications for further research to design an optimal "tax" structure for extracting revenues in a dual currency economy.