Persistent Real Exchange Rates

Alok Johri and Amartya Lahiri

Department of Economics Working Papers from McMaster University

Abstract: Three well known facts that characterize exchange rate data are: (a) the high correlation between bilateral nominal and real exchange rates; (b) the high degree of persistence in real exchange rate movements; and (c) the high volatility of real exchange rates. This paper attempts a joint, albeit partial, rationalization of these facts in an environment with no staggered contracts and where prices are preset for only one quarter. There are two key innovations in the paper. First, we augment a standard two-country open economy model with learning-by-doing in production at the firm level. This induces monopolistically competitive firms to endogeneize the productivity effect of their price setting behavior. Specifically, firms endogenously choose not to adjust prices by the full proportion of a positive monetary shock in order to take advantage of the productivity benefits of higher production. Second, we introduce habits in leisure. This makes the labor supply decision dynamic and adds an additional source of propagation. We show that the calibrated model can quantitatively reproduce significant fractions of the aforementioned facts. Moreover, as in the data, the model also produces a positive correlation between the terms of trade and the nominal exchange rate.

Keywords: Real exchange rate movements; endogenous price stickiness; learning-by-doing (search for similar items in EconPapers)
JEL-codes: F1 F2 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2008-06
New Economics Papers: this item is included in nep-cba, nep-dge, nep-ifn and nep-opm
References: Add references at CitEc
Citations: View citations in EconPapers (33)

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Related works:
Journal Article: Persistent real exchange rates (2008)
Working Paper: Persistent Real Exchange Rates (2006)
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Persistent link: https://EconPapers.repec.org/RePEc:mcm:deptwp:2008-04

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