Credit Market Imperfections and Exchange Rate Variability

In this paper a two-country overlapping generations model is presented in which the roles of financial factors in the international monetary transmission mechanism are studied and whether and how the two types of credit market imperfections, limited participation and costly state verification, may contribute to the high variability of exchange rates are examined. Liquidity effects generated by monetary disturbances are shown to have qualitatively similar effects on the world economy in the perfect information case and in the costly information case. However, quantitative differences provide different predictions about the variability of economic variables in the world economy