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Solving Exchange Rate Puzzles with neither Sticky Prices nor Trade Costs

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  • Maurice J. Roche

    ()
    (Department of Economics, Ryerson University, Toronto, Canada)

  • Michael J. Moore

    ()
    (School of Management and Economics, The Queen's University of Belfast, Belfast, Northern Ireland)

Abstract

We present a simple framework in which both the exchange rates disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with deep? habits. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese-Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression.

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Bibliographic Info

Paper provided by Ryerson University, Department of Economics in its series Working Papers with number 001.

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Length: 47 pages
Date of creation: Oct 2009
Date of revision:
Handle: RePEc:rye:wpaper:wp001

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Keywords: Exchange Rate Puzzles; Forward Foreign Exchange; Habit Persistence;

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Cited by:
  1. 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.
  2. Emanuel Kohlscheen, 2011. "The Impact of Monetary Policy on the Exchange Rate: puzzling evidence from three emerging economies," Working Papers Series 259, Central Bank of Brazil, Research Department.
  3. Martin D. D. Evans, 2012. "Exchange-Rate Dark Matter," IMF Working Papers 12/66, International Monetary Fund.
  4. Jingyi Liu, 2008. "Can a Lucas model with habit generate realistic conditional volatility in exchange rate returns?," ESE Discussion Papers 181, Edinburgh School of Economics, University of Edinburgh.
  5. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.
  6. Gianluca Benigno & Pierpaolo Benigno & Salvatore Nisticò, 2011. "Risk, Monetary Policy and the Exchange Rate," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 247-309 National Bureau of Economic Research, Inc.
  7. Francis Breedon & Dagfinn Rime & Paolo Vital, 2010. "A Transaction Data Study of the Forward Bias Puzzle," Working Paper 2010/26, Norges Bank.
  8. Menzie D. Chinn & Michael J. Moore, 2008. "Private Information and a Macro Model of Exchange Rates: Evidence from a Novel Data Set," NBER Working Papers 14175, National Bureau of Economic Research, Inc.
  9. Maurice J. Roche & Michael J. Moore, 2010. "For Rich or for Poor: When does Uncovered Interest Parity Hold?," Working Papers 015, Ryerson University, Department of Economics.
  10. Andreas Stathopoulos, 2012. "Portfolio Home Bias and External Habit Formation," 2012 Meeting Papers 502, Society for Economic Dynamics.
  11. Snaith, Stuart & Coakley, Jerry & Kellard, Neil, 2013. "Does the forward premium puzzle disappear over the horizon?," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3681-3693.
  12. De Paoli, Bianca & Sondergaard, Jens, 2009. "Foreign exchange rate risk in a small open economy," Bank of England working papers 365, Bank of England.
  13. Moore, Michael J. & Roche, Maurice J., 2012. "When does uncovered interest parity hold?," Journal of International Money and Finance, Elsevier, vol. 31(4), pages 865-879.

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