By Athanasios Geromichalos and Kuk Mo Jung
http://d.repec.org/n?u=RePEc:pra:mprapa:64402&r=dge
The FOREX market is an over-the-counter market (in fact, the largest in the world) characterized by bilateral trade, intermediation, and significant bid-ask spreads. The existing international macroeconomics literature has failed to account for these stylized facts largely due to the fact that it models the FOREX as a standard Walrasian market, therefore overlooking some important institutional details of this market. In this paper, we build on recent developments in monetary theory and finance to construct a dynamic general equilibrium model of intermediation in the FOREX market. A key concept in our approach is that immediate trade between ultimate buyers and sellers of foreign currencies is obstructed by search frictions (e.g., due to geographic dispersion). We use our framework to compute standard measures of FOREX market liquidity, such as bid-ask spreads and trade volume, and to study how these measures are affected both by macroeconomic fundamentals and the FOREX market microstructure. We also show that the FOREX market microstructure critically affects the volume of international trade and, consequently, welfare. Hence, our paper highlights that modeling the FOREX as a frictionless Walrasian market is not without loss of generality.
The foreign exchange market is modelled in an incredibly naive way, incredible given the size of the market. And despite its size, there are sizable frictions and many missing bilateral markets. This paper is an important step n the direction of modelling the microfoundations of this market to better understand how issues in intermediation can have macroeconomic, even global, implications.
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