Idiosyncratic tastes in a two-country optimizing model: implications ; of a standard presumption
International spillovers and exchange rate dynamics are examined in a two-country dynamic optimizing model that allows for idiosyncratic tastes across countries. Specifically, there is a home-good bias in consumption patterns: at given relative prices the ratio of home goods consumed to foreign goods consumed is higher in the home country. The setup nests Obstfeld and Rogoff (1995), who assume identical tastes. Allowing for idiosyncratic tastes produces results that differ from Obstfeld and Rogoff's expansionary monetary policy increases home utility by more, the positive spillovers of a fiscal expansion are reduced, and both short-run and long-run deviations from consumption-based purchasing power parity are possible. The model's predictions are broadly consistent with those from the Frenkel, Razin and Yuen (1996) version of the two-country Mundell-Fleming model and with observed behavior of real and nominal exchange rates.
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