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Euro-Dollar Real Exchange Rate Dynamics in an Estimated Two-Country Model: What Is Important and What Is Not

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Pau Rabanal
Vicente Tuesta

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Abstract

We use a Bayesian approach to estimate a standard two-country New Open Economy Macroeconomics model using data for the United States and the euro area, and we perform model comparisons to study the importance of departing from the law of one price and complete markets assumptions. Our results can be summarized as follows. First, we find that the baseline model does a good job in explaining real exchange rate volatility but at the cost of overestimating volatility in output and consumption. Second, the introduction of incomplete markets allows the model to better match the volatilities of all real variables. Third, introducing sticky prices in Local Currency Pricing improves the fit of the baseline model but does not improve the fit as much as introducing incomplete markets. Finally, we show that monetary shocks have played a minor role in explaining the behavior of the real exchange rate, while both demand and technology shocks have been important.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/177.

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Length: 42 pages
Date of creation: 03 Aug 2006
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Handle: RePEc:imf:imfwpa:06/177

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Keywords: Real exchange rates ; Bayesian estimation ; model comparison ; Euro ; U.S. dollar ; Real effective exchange rates ; Economic models ;

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This paper has been announced in the following NEP Reports: References listed on IDEAS
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  4. Stockman, Alan C & Tesar, Linda L, 1995. "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," American Economic Review, American Economic Association, vol. 85(1), pages 168-85, March. [Downloadable!] (restricted)
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  6. Alejandro Justiniano & Bruce Preston, 2006. "Can Structural Small Open Economy Models Account for the Influence of Foreign Disturbances?," 2006 Meeting Papers 479, Society for Economic Dynamics. [Downloadable!]
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  7. Pau Rabanal & Jordi Galí, 2005. "Technology Shocks and Aggregate Fluctuations: How Well Does the RBC Model Fit Postwar U.S. Data?," IMF Working Papers 04/234, International Monetary Fund. [Downloadable!]
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  8. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Blackwell Publishing, vol. 70(4), pages 743-764, October. [Downloadable!] (restricted)
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  16. Corsetti, Giancarlo & Dedola, Luca & Leduc, Sylvain, 2004. "International Risk Sharing and the Transmission of Productivity Shocks," CEPR Discussion Papers 4746, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  19. Benigno, Gianluca & Thoenissen, Christoph, 2006. "Consumption and Real Exchange Rates with Incomplete Markets and Non-Traded Goods," CEPR Discussion Papers 5580, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  28. Marco Del Negro & Frank Schorfheide & Frank Smets & Raf Wouters, 2005. "On the fit and forecasting performance of New-Keynesian models," Working Paper Series 491, European Central Bank. [Downloadable!]
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  29. Frank Smets & Rafael Wouters, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 171, European Central Bank. [Downloadable!]
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  35. Jorge Selaive & Vicente Tuesta, 2003. "Net foreign assets and imperfect pass-through: the consumption real exchange rate anomaly," International Finance Discussion Papers 764, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  36. Benigno, Pierpaolo, 2001. "Price Stability with Imperfect Financial Integration," CEPR Discussion Papers 2854, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  37. Pau Rabanal, 2004. "Monetary Policy Rules and the U.S. Business Cycle: Evidence and Implications," IMF Working Papers 04/164, International Monetary Fund. [Downloadable!]
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Frank Smets & Matthieu Darracq Pariès & Stéphane Adjemian, 2008. "A quantitative perspective on optimal monetary policy cooperation between the US and the euro area," Working Paper Series 884, European Central Bank. [Downloadable!]
  2. 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. [Downloadable!]
  3. Andrea Nobili & Stefano Neri, 2006. "The transmission of monetary policy shocks from the US to the euro area," Temi di discussione (Economic working papers) 606, Bank of Italy, Economic Research Department. [Downloadable!]
  4. Riccardo Cristadoro & Andrea Gerali & Stefano Neri & Massimiliano Pisani, 2008. "Real exchange rate volatility and disconnect: an empirical investigation," Temi di discussione (Economic working papers) 660, Bank of Italy, Economic Research Department. [Downloadable!]
  5. Alejandro Justiniano & Bruce Preston, 2008. "Can Structural Small Open Economy Models Account for the Influence of Foreign Disturbances?," NBER Working Papers 14547, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  6. Martin Bodenstein, 2006. "Closing open economy models," International Finance Discussion Papers 867, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  7. Benigno, Gianluca & Thoenissen, Christoph, 2006. "Consumption and Real Exchange Rates with Incomplete Markets and Non-Traded Goods," CEPR Discussion Papers 5580, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  8. An, Sungbae & Schorfheide, Frank, 2005. "Bayesian Analysis of DSGE Models," CEPR Discussion Papers 5207, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  9. P. Jacob & G. Peersman, 2008. "Dissecting the Dynamics of the US Trade Balance in an Estimated Equilibrium Model," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium 08/544, Ghent University, Faculty of Economics and Business Administration. [Downloadable!]
  10. Matthieu Darracq Pariès & Alessandro Notarpietro, 2008. "Monetary policy and housing prices in an estimated DSGE model for the US and the euro area," Working Paper Series 972, European Central Bank. [Downloadable!]
  11. Paul Castillo & Carlos Montoro & Vicente Tuesta, 2006. "Stylized Facts of the Peruvian Economy," Working Papers 2006-005, Banco Central de Reserva del Perú. [Downloadable!]
  12. Jorge Selaive & Vicente Tuesta, 2006. "The Consumption-Real Exchange Rate Anomaly: Non-Traded Goods, Incomplete Markets and Distribution Services," Working Papers Central Bank of Chile 359, Central Bank of Chile. [Downloadable!]
  13. Martin Bodenstein, 2008. "Trade elasticity of substitution and equilibrium dynamics," International Finance Discussion Papers 934, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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