We study the behavior of real exchange rates in a twocountry dynamic equilibrium model. In this model, consumers can only consume domestic goods but can invest costlessly in capital stocks of both countries. Nevertheless, transporting goods between the two countries is costly and, hence, the rebalancing of the capital stock can only happen finitely often. We propose a realistic cost structure for goods transportation, wherein the total cost increases with the amount of shipment but the unit cost decreases with it due to economies of scale. Given such a cost structure, the optimal decisions on when and how much to transfer need to be determined jointly. The dual decision depends upon the magnitude of economies of scale, the production technology specifications, and the consumer preferences. The model can reconcile the observed large shortterm volatility of the real exchange rate with its slow convergence to parity. Further, the drift and diffusion of the real exchange rate are not uniquely determined by the real exchange rate level. The dynamics of the real exchange rate can only be determined by a joint analysis of the real exchange rate and the underlying economic fundamentals such as the capital stock imbalance between the two countries.
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Paper provided by EconWPA in its series Finance with number
0207016.
Length: 35 pages Date of creation: 30 Aug 2002 Date of revision: Handle: RePEc:wpa:wuwpfi:0207016
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Find related papers by JEL classification: C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation F31 - International Economics - - International Finance - - - Foreign Exchange G12 - Financial Economics - - General Financial Markets - - - Asset Pricing G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
References listed on IDEAS 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.:
Froot, Kenneth A. & Kim, Michael & Rogoff, Kenneth, 1995.
"The Law of One Price Over 700 Years,"
Working Papers
95-13, C.V. Starr Center for Applied Economics, New York University.
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