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The real exchange rate in sticky-price models: does investment matter?

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  • Martinez-Garcia, Enrique

    ()
    (Federal Reserve Bank of Dallas)

  • Sondergaard, Jens

    ()
    (Bank of England)

Abstract

This paper re-examines the ability of sticky-price models to generate volatile and persistent real exchange rates. We use a DSGE framework with pricing to market to illustrate the link between real exchange rate dynamics and what the model assumes about physical capital. We show that adding capital accumulation to the model facilitates consumption smoothing and significantly impedes the model's ability to generate volatile real exchange rates. Our analysis, therefore, caveats earlier work that has shown how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that so-called persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilisation and investment adjustment costs. In summary, the PPP puzzle is still very much alive and well.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 368.

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Length: 47 pages
Date of creation: 27 Apr 2009
Date of revision:
Handle: RePEc:boe:boeewp:0368

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Keywords: Real exchange rates; capital accumulation; Taylor rules.;

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References

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Citations

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Cited by:
  1. Onishchenko, Kateryna, 2011. "Can a pure real business cycle model explain the real exchange rate: the case of Ukraine," Cardiff Economics Working Papers E2011/17, Cardiff University, Cardiff Business School, Economics Section.
  2. Enrique Martinez-Garcia & Jens Sondergaard, 2009. "Investment and trade patterns in a sticky-price, open-economy model," Globalization and Monetary Policy Institute Working Paper 28, Federal Reserve Bank of Dallas.
  3. Carlos Carvalho & Fernanda Nechio, 2011. "Aggregation and the PPP Puzzle in a Sticky-Price Model," American Economic Review, American Economic Association, vol. 101(6), pages 2391-2424, October.
  4. Carvalho, Carlos & Nechio, Fernanda, 2014. "Monetary policy and real exchange rate dynamics in sticky-price models," Working Paper Series 2014-17, Federal Reserve Bank of San Francisco.
  5. Enrique Martinez-Garcia, 2008. "Globalization and monetary policy: an introduction," Globalization and Monetary Policy Institute Working Paper 11, Federal Reserve Bank of Dallas.

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