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Exchange rate dynamics and the welfare effects of monetary policy in a two-country model with home-product bias

  • Francis E. Warnock
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    International spillovers and exchange rate dynamics are examined in a two-country dynamic optimizing model that allows for home-product 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. With home bias, results are different in three ways. When preferences are biased, the wealth transfers associated with current account imbalances induce movements in the real exchange rate and produce large short-run and small long-run deviations from consumption-based purchasing power parity. With home bias, interest rates, both real and nominal, can differ across countries; relatedly, home bias is a necessary but not sufficient condition for Dornbusch (1976) type exchange rate overshooting. Finally, in this model the welfare effects of expansionary monetary policy depend not only on world demand but also on the expenditure-switching effect of an exchange rate depreciation; monetary policy is `beggar-thy-neighbor' if individuals have strong preferences for domestic products, but can be `beggar-thyself' if, instead, imported goods are preferred.

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    File URL: http://www.federalreserve.gov/pubs/ifdp/2000/667/default.htm
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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 667.

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    Date of creation: 2000
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    Handle: RePEc:fip:fedgif:667
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    1. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "New directions for stochastic open economy models," Journal of International Economics, Elsevier, vol. 50(1), pages 117-153, February.
    2. Evan F. Koenig, 1989. "Real money balances and the timing of consumption: an empirical investigation," Research Paper 8906, Federal Reserve Bank of Dallas.
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    4. Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
    5. Charles Engel & John H. Rogers, 1995. "How wide is the border?," Research Working Paper 95-09, Federal Reserve Bank of Kansas City.
    6. Dixit, Avinash K & Stiglitz, Joseph E, 1975. "Monopolistic Competition and Optimum Product Diversity," The Warwick Economics Research Paper Series (TWERPS) 64, University of Warwick, Department of Economics.
    7. Isard, Peter, 1977. "How Far Can We Push the "Law of One Price"?," American Economic Review, American Economic Association, vol. 67(5), pages 942-48, December.
    8. Sutherland, Alan, 1996. "Exchange Rate Dynamics and Financial Market Integration," CEPR Discussion Papers 1337, C.E.P.R. Discussion Papers.
    9. Lane, Philip R., 1999. "The New Open Economy Macroeconomics: a Survey," CEPR Discussion Papers 2115, C.E.P.R. Discussion Papers.
    10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    11. Mankiw, N Gregory & Summers, Lawrence H, 1986. "Money Demand and the Effects of Fiscal Policies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 18(4), pages 415-29, November.
    12. Laurence M. Ball & David Romer, 1987. "Are Prices Too Sticky?," NBER Working Papers 2171, National Bureau of Economic Research, Inc.
    13. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
    14. Hairault, Jean-Olivier & Portier, Franck, 1993. "Money, New-Keynesian macroeconomics and the business cycle," European Economic Review, Elsevier, vol. 37(8), pages 1533-1568, December.
    15. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
    16. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
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