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Solving Exchange Rate Puzzles with neither Sticky Prices nor Trade Costs

  • Maurice J. Roche

    ()

    (Department of Economics, Ryerson University, Toronto, Canada)

  • Michael J. Moore

    ()

    (School of Management and Economics, The Queen's University of Belfast, Belfast, Northern Ireland)

We present a simple framework in which both the exchange rates disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with deep? habits. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese-Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression.

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Paper provided by Ryerson University, Department of Economics in its series Working Papers with number 001.

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Length: 47 pages
Date of creation: Oct 2009
Date of revision:
Handle: RePEc:rye:wpaper:wp001
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