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Dynamics of Endogenous Business Cycles and Exchange Rate Volatility

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  • Volker Böhm
  • Tomoo Kikuchi
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    Abstract

    This paper studies dynamics of endogenous business cycles and exchange rate volatility in a small open economy. Without market imperfections, domestic price and wage adjustments respond sluggishly to disequilibrium situations on real domestic markets while prices on international capital markets adjust instantaneously. The expectation formation mechanism under uncovered interest rate parity (UIP) induces a channel transmitting potential domestic real fluctuations into exchange rate fluctuations and vice versa. The interaction of the expectations feed back with the adjustment mechanism causes exchange rates to exhibit a higher volatility than other prices. The numerical analysis shows examples which confirm the typical empirically observed high volatility of nominal exchange rates compared with that of real/domestic variables.

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    File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2002/wp-cesifo-2002-10/cesifo_wp797.pdf
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    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 797.

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    Date of creation: 2002
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    Handle: RePEc:ces:ceswps:_797

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    Related research

    Keywords: This paper studies dynamics of endogenous business cycles and exchange rate volatility in a small open economy. Without market imperfections; domestic price and wage adjustments respond sluggishly to disequilibrium situations on real domestic markets whil;

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    1. Maurice Obstfeld and Kenneth Rogoff., 2000. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," Center for International and Development Economics Research (CIDER) Working Papers C00-112, University of California at Berkeley.
    2. Chari, V V & Kehoe, Patrick J & McGrattan, Ellen R, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Wiley Blackwell, vol. 69(3), pages 533-63, July.
    3. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
    4. Robert Kollmann, 2001. "The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation," ULB Institutional Repository 2013/7630, ULB -- Universite Libre de Bruxelles.
    5. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
    6. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August.
    7. Barro, Robert J & Grossman, Herschel I, 1971. "A General Disequilibrium Model of Income and Employment," American Economic Review, American Economic Association, vol. 61(1), pages 82-93, March.
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