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Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles

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  • V. V. Chari
  • Patrick J. Kehoe
  • Ellen R. McGrattan

Abstract

The data show large and persistent deviations of real exchange rates from purchasing power parity. Recent work has shown that to a large extent these movements are driven by deviations from the law of one price for traded goods. In the data, real and nominal exchange rates are about 6 times as volatile as relative price levels and they both are highly persistent, with serial correlations of 0.85 and 0.83, respectively. This paper develops a sticky price model with price discriminating monopolists, which produces deviations from the law of one price for traded goods. Our benchmark model, which has prices set for one quarter at a time and a unit consumption elasticity of money demand, does not come close to reproducing these observations. A model which has producers setting prices for 6 quarters at a time and a consumption elasticity of money demand of 0.27 does much better. In it real and nominal exchange rates are about 3 times as volatile as relative price levels and exchange rates are persistent, with serial correlations of 0.65 and 0.66, respectively.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5876.

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Date of creation: Jan 1997
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Handle: RePEc:nbr:nberwo:5876

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  1. Hodrick, Robert J & Prescott, Edward C, 1997. "Postwar U.S. Business Cycles: An Empirical Investigation," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 29(1), pages 1-16, February.
  2. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1998. "Sticky price models of the business cycle: can the contract multiplier solve the persistence problem?," Staff Report, Federal Reserve Bank of Minneapolis 217, Federal Reserve Bank of Minneapolis.
  3. Pinelopi Koujianou Goldberg & Michael M. Knetter, 1997. "Goods Prices and Exchange Rates: What Have We Learned?," Journal of Economic Literature, American Economic Association, vol. 35(3), pages 1243-1272, September.
  4. Ohanian, Lee E & Stockman, Alan C, 1997. "Short-Run Independence of Monetary Policy under Pegged Exchange Rates and Effects of Money on Exchange Rates and Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 29(4), pages 783-806, November.
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  7. Blanchard, Olivier Jean & Kiyotaki, Nobuhiro, 1987. "Monopolistic Competition and the Effects of Aggregate Demand," American Economic Review, American Economic Association, vol. 77(4), pages 647-66, September.
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  9. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 25(1), pages 117-214, January.
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  11. Kollmann, R., 1996. "The Exchange rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: A Quantitative Investigation," Discussion Paper, Tilburg University, Center for Economic Research 1996-67, Tilburg University, Center for Economic Research.
  12. Paul Krugman, 1986. "Pricing to Market when the Exchange Rate Changes," NBER Working Papers 1926, National Bureau of Economic Research, Inc.
  13. Ellen R. McGrattan, 1993. "Solving the stochastic growth model with a finite element method," Staff Report, Federal Reserve Bank of Minneapolis 164, Federal Reserve Bank of Minneapolis.
  14. Chari, V V & Christiano, Lawrence J & Kehoe, Patrick J, 1994. "Optimal Fiscal Policy in a Business Cycle Model," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 102(4), pages 617-52, August.
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  16. repec:nbr:nberre:0126 is not listed on IDEAS
  17. Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers, University of California at Berkeley C95-048, University of California at Berkeley.
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  19. Dixit, Avinash K & Stiglitz, Joseph E, 1975. "Monopolistic Competition and Optimum Product Diversity," The Warwick Economics Research Paper Series (TWERPS) 64, University of Warwick, Department of Economics.
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