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Solving exchange rate puzzles with neither sticky prices nor trade costs

  • Moore, Michael J.
  • Roche, Maurice J.

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 along the lines of the work of Ravn, Schmitt-Grohe and Uribe. 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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Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 29 (2010)
Issue (Month): 6 (October)
Pages: 1151-1170

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Handle: RePEc:eee:jimfin:v:29:y:2010:i:6:p:1151-1170
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

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