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

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  • Enrique Martinez-Garcia
  • Jens Søndergaard

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 akin to those in Chari, et al. (2002) and Steinsson (2008) 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 the results in Steinsson (2008) who shows how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that the CKM (2002) persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilization and investment adjustment costs (see, e.g., Christiano, et al., 2005). In summary, the PPP puzzle is still very much alive and well.

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Paper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 17.

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Date of creation: 2008
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Handle: RePEc:fip:feddgw:17

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Keywords: Globalization ; Foreign exchange ; International finance ; Forecasting ; Mathematical models;

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  3. Enrique Martinez-Garcia, 2007. "A monetary model of the exchange rate with informational frictions," Globalization and Monetary Policy Institute Working Paper 02, Federal Reserve Bank of Dallas.
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Citations

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Cited by:
  1. Enrique Martinez-Garcia, 2008. "Globalization and monetary policy: an introduction," Globalization and Monetary Policy Institute Working Paper 11, Federal Reserve Bank of Dallas.
  2. 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.
  3. 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.
  4. 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.

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