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The real exchange rate in sticky-price models: does investment matter?

Author

Listed:
  • Martinez-Garcia, Enrique

    () (Federal Reserve Bank of Dallas)

  • Sondergaard, Jens

    () (Bank of England)

Abstract

This paper re-examines the ability of sticky-price models to generate volatile and persistent real exchange rates. We use a DSGE framework with pricing to market to illustrate the link between real exchange rate dynamics and what the model assumes about physical capital. We show that adding capital accumulation to the model facilitates consumption smoothing and significantly impedes the model's ability to generate volatile real exchange rates. Our analysis, therefore, caveats earlier work that has shown how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that so-called persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilisation and investment adjustment costs. In summary, the PPP puzzle is still very much alive and well.

Suggested Citation

  • Martinez-Garcia, Enrique & Sondergaard, Jens, 2009. "The real exchange rate in sticky-price models: does investment matter?," Bank of England working papers 368, Bank of England.
  • Handle: RePEc:boe:boeewp:0368
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    Cited by:

    1. Martinez-Garcia, Enrique & Sondergaard, Jens, 2009. "Investment and trade patterns in a sticky-price, open-economy model," Globalization Institute Working Papers 28, Federal Reserve Bank of Dallas.
    2. Carlos Viana de Carvalho & Fernanda Feitosa Necchio, 2014. "Monetary Policy and Real Exchange Rate Dynamics in Sticky-Price Models," Textos para discussão 628, Department of Economics PUC-Rio (Brazil).
    3. Kateryna Onishchenko, 2012. "Can a pure real business cycle model explain the real exchange rate: the case of Ukraine," International Journal of Sustainable Economy, Inderscience Enterprises Ltd, vol. 4(2), pages 111-135.
    4. Enrique Martinez-Garcia, 2008. "Globalization and monetary policy: an introduction," Globalization Institute Working Papers 11, Federal Reserve Bank of Dallas.
    5. Carlos Carvalho & Fernanda Nechio, 2011. "Aggregation and the PPP Puzzle in a Sticky-Price Model," American Economic Review, American Economic Association, vol. 101(6), pages 2391-2424, October.

    More about this item

    Keywords

    Real exchange rates; capital accumulation; Taylor rules.;

    JEL classification:

    • F11 - International Economics - - Trade - - - Neoclassical Models of Trade
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
    • F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies

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