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

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  • Martinez-Garcia, Enrique

    () (Federal Reserve Bank of Dallas)

  • Søndergaard, Jens

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 akin to those in Chari, et al. (2002) and Steinsson (2008) 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 the results in Steinsson (2008) who shows how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that the CKM (2002) persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilization and investment adjustment costs (see, e.g., Christiano, et al., 2005). In summary, the PPP puzzle is still very much alive and well.

Suggested Citation

  • Martinez-Garcia, Enrique & Søndergaard, Jens, 2008. "The real exchange rate in sticky price models: does investment matter?," Globalization and Monetary Policy Institute Working Paper 17, Federal Reserve Bank of Dallas.
  • Handle: RePEc:fip:feddgw:17 Note: Published as: Martinez-Garcia, Enrique and Jens Søndergaard (2013), "Investment and Real Exchange in Sticky Price Models," Macroeconomic Dynamics17 (2): 195-234.
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    Cited by:

    1. 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, pages 111-135.
    2. Enrique Martinez-Garcia, 2008. "Globalization and monetary policy: an introduction," Globalization and Monetary Policy Institute Working Paper 11, Federal Reserve Bank of Dallas.
    3. Martinez-Garcia, Enrique & Sondergaard, Jens, 2009. "Investment and trade patterns in a sticky-price, open-economy model," Globalization and Monetary Policy Institute Working Paper 28, Federal Reserve Bank of Dallas.
    4. Carvalho, Carlos & Nechio, Fernanda & Yao, Fang, 2014. "Monetary Policy and Real Exchange Rate Dynamics in Sticky-Price Models," Working Paper Series 2014-17, Federal Reserve Bank of San Francisco, revised Sep 2017.
    5. Carlos Carvalho & Fernanda Nechio, 2011. "Aggregation and the PPP Puzzle in a Sticky-Price Model," American Economic Review, American Economic Association, pages 2391-2424.

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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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