Information Frictions and Real Exchange Rate Dynamics

The paper provides a novel explanation for the observed large and persistent fluctuations in real exchange rate dynamics using a flexible-price model with dispersed information among firms. The paper extend the imperfect common knowledge model developed by Woodford (2002) and Melosi (2014) to a two-country environment. The model is estimated on US and European data using Bayesian methods. The model successfully explain the volatility and persistence of the US/Euro Area real exchange rate, as well as its high correlation with the nominal exchange rate. In line with the empirical evidence, the estimated model delivers hump-shaped dynamics for real exchange rate and highly persistent effect of monetary disturbances. A battery of results shows that the model with information frictions outperforms traditional sticky-price models of real exchange rates.