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Net Foreign Assets and the Exchange Rate: Redux Revived

  • Michele Cavallo

    (New York University)

  • Fabio Ghironi

    ()

    (Boston College)

We revisit Obstfeld and Rogoff's (1995) results on exchange rate dynamics in a two-country, monetary model with incomplete asset markets, stationary net foreign assets, and endogenous nominal interest rate setting a la Taylor (1993). Under flexible prices, the nominal exchange rate exhibits a unit root. However, today's exchange rate also depends on the stock of real net foreign assets accumulated in the previous period. The predictive power of net assets for the exchange rate is stronger the closer assets to non-stationary and the higher the degree of substitutability between domestic and foreign goods in consumption. When prices are sticky, the exchange rate still exhibits a unit root. The current level of the exchange rate depends on the past GDP differential, along with net foreign assets. Endogenous monetary policy and asset dynamics have consequences for exchange rate overshooting under both flexible and sticky prices.

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Paper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 505.

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Length: 70 pages
Date of creation: 26 Aug 2000
Date of revision: 01 Feb 2002
Publication status: Published, Journal of Monetary Economics, 2002, 49, 1057-1097
Handle: RePEc:boc:bocoec:505
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