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Real exchange rate convergence: The roles of price stickiness and monetary policy

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  • Engel, Charles

Abstract

In many open-economy models based on Dornbusch (1976), the speed of convergence of the real exchange rate is tied to the stickiness of prices. The “purchasing power parity puzzle” concerns the empirical fact that real exchange rates appear to converge more slowly than nominal prices. In some New Keynesian models, when there is no interest-rate smoothing, the stickiness of prices does not matter at all for persistence, as Benigno (2004) showed. We show that in the presence of interest-rate smoothing, price stickiness does matter and endogenous real-exchange rate persistence is bounded above by the interest rate smoothing parameter and by the probability of a firm not changing prices under Calvo pricing. We also explain the relationship between the New Keynesian framework with Calvo pricing, and the Dornbusch framework where price stickiness is integral to real exchange rate convergence.

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  • Engel, Charles, 2019. "Real exchange rate convergence: The roles of price stickiness and monetary policy," Journal of Monetary Economics, Elsevier, vol. 103(C), pages 21-32.
    • Handle: RePEc:eee:moneco:v:103:y:2019:i:c:p:21-32
    DOI: 10.1016/j.jmoneco.2018.08.007
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    4. Yusuf Ömür Yılmaz, 2021. "Real Exchange Rate Dynamics in Model with Habit Formation," Bogazici Journal, Review of Social, Economic and Administrative Studies, Bogazici University, Department of Economics, vol. 35(1), pages 26-49.
    5. Mario J. Crucini & Mototsugu Shintani & Takayuki Tsuruga, 2020. "A Behavioral Explanation for the Puzzling Persistence of the Aggregate Real Exchange Rate," NBER Working Papers 27420, National Bureau of Economic Research, Inc.
    6. Kano, Kazuko & Kano, Takashi, 2021. "Welfare Costs of Exchange Rate Fluctuations: Evidence from the 1972 Okinawa Reversion," Discussion paper series HIAS-E-114, Hitotsubashi Institute for Advanced Study, Hitotsubashi University.
    7. Charles Engel & Steve Pak Yeung Wu, 2023. "Liquidity and Exchange Rates: An Empirical Investigation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 90(5), pages 2395-2438.
    8. Kamalyan, Hayk, 2023. "Real exchange rate dynamics in the New-Keynesian model," International Economics, Elsevier, vol. 174(C), pages 250-255.
    9. Takashi Kano, 2021. "Exchange Rates and Fundamentals: A General Equilibrium Exploration," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 53(1), pages 95-117, February.
    10. Nakamura, Fumitaka, 2022. "The origin of the law of one price deviations: Insights from the good-level real exchange rate volatility," Journal of International Money and Finance, Elsevier, vol. 128(C).
    11. Hai Long Vo & Duc Hong Vo, 2023. "The purchasing power parity and exchange‐rate economics half a century on," Journal of Economic Surveys, Wiley Blackwell, vol. 37(2), pages 446-479, April.
    12. Beckmann, Joscha & Breitenlechner, Max & Scharler, Johann, 2024. "Is the exchange rate a shock absorber? The shocks matter," International Review of Economics & Finance, Elsevier, vol. 89(PB), pages 114-130.
    13. Hertrich, Markus, 2020. "Foreign exchange interventions under a one-sided target zone regime and the Swiss franc," Discussion Papers 21/2020, Deutsche Bundesbank.
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    More about this item

    Keywords

    Real exchange rates; Purchasing power parity; Inflation persistence; Sticky prices;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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