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Why Is the Business Cycle Behavior of Fundamentals Alike Across Exchange Rate Regimes?

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  • Sylvain Leduc

    (Federal Reserve Bank of Philadelphia)

Abstract

This paper develops a two-country, two-sector general equilibrium business cycle model with nominal rigidities featuring deviations from the law of one price. We show that a model with such building blocks can quantitatively account for the empirical fact that, of the statistical properties of most macroeconomic variables, only the volatility of the real and nominal exchange rates has dramatically changed after the fall of the Bretton Woods system. In particular, we replicate some explicit benchmark tests proposed in the literature (for instance, by Flood and Rose (1995)) with simulated data from our artificial economy. The presence of firms pricing-to-market and different speeds of price adjustment across sectors is important in generating the results. We show that these features dampen the upward impact of monetary policy shocks, following the introduction of a flexible exchange rate regime, on the volatility of output, consumption and especially net exports. In our model, the increase in the volatility of the real exchange rate, when the currency floats is due to an increase in the covariance of relative prices across countries. Since the variance of relative prices is not affected by the exchange rate regime, neither is that of most other macroeconomic variables.

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Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1843.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1843

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Cited by:
  1. Kollmann, Robert, 2005. "Macroeconomic effects of nominal exchange rate regimes: new insights into the role of price dynamics," Journal of International Money and Finance, Elsevier, vol. 24(2), pages 275-292, March.
  2. Calderon, Cesar & Kubota, Megumi, 2009. "Does higher openness cause more real exchange rate volatility ?," Policy Research Working Paper Series 4896, The World Bank.
  3. Kollmann, Robert, 2002. "Monetary policy rules in the open economy: effects on welfare and business cycles," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 989-1015, July.
  4. Reinhart, Carmen, 2002. "A Modern History of Exchange Rate Arrangements: The Country Histories, 1946-2001," MPRA Paper 13191, University Library of Munich, Germany.
  5. Carmen M. Reinhart & Kenneth S. Rogoff, 2002. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Papers 8963, National Bureau of Economic Research, Inc.
  6. Riccardo Cristadoro & Andrea Gerali & Stefano Neri & Massimiliano Pisani, 2006. "Nominal Rigidities in an Estimated Two Country," Computing in Economics and Finance 2006 162, Society for Computational Economics.
  7. Stavarek, Daniel, 2013. "Cyclical relationship between exchange rates and macro-fundamentals in Central and Eastern Europe," MPRA Paper 45327, University Library of Munich, Germany.
  8. Theptida Sopraseuth, 2003. "Exchange Rate Regimes and International Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(2), pages 338-361, April.
  9. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2005. "DSGE Models of High Exchange-Rate Volatility and Low Pass-Through," Economics Working Papers ECO2005/23, European University Institute.
  10. Reinhart, Carmen, 2002. "A Modern History of Exchange Rate Arrangements: Parallel Markets and Dual and Multiple Exchange Rates," MPRA Paper 13194, University Library of Munich, Germany.
  11. Reinhart, Carmen, 2002. "A Modern History of Exchange Rate Arrangements: Chartbook, 1946-2001," MPRA Paper 13192, University Library of Munich, Germany.

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