The Dynamic Behavior of the Real Exchange Rate in Sticky Price Models

Abstract

Since the breakdown of the Bretton Woods system of fixed exchange rates, the real exchange rates of the world’s largest economies have been highly volatile. Furthermore, swings in these real exchange rates have been highly persistent. A large recent literature has studied whether the volatility and persistence of real exchange rates can be understood in the context of sticky price models with staggered price setting. This literature was pioneered by V. V. Chari, Patrick J. Kehoe, and Ellen R. McGrattan (2002). They concluded that such models can explain the volatility of the real exchange rate but that they cannot match its persistence. A number of subsequent papers have sought to address this “persistence anomaly” by introducing various forms of strategic complementarity and asymmetry, as well as sticky wages and persistent monetary policy (Paul Bergin and Robert C. Feenstra 2001; Gianluca Benigno 2004; Jan J. J. Groen and Akito Matsumoto 2004; Jens Sondergaard 2004; Hafedh Bouakez 2005). While these features increase the persistence of the real exchange rate considerably, they are not sufficient to match the half-life of the real exchange rate seen in the data. Existing empirical evidence suggests that real exchange rates exhibit hump-shaped dynamics (John Huizinga 1987; Martin S. Eichenbaum and Charles L. Evans 1995; Yin-Wong Cheung and Kon S. Lai 2000). I show that this is a robust empirical fact for nine large, developed economies. I estimate an autoregressive model for the real exchange rate of each economy. The estimated short-term dynamics cause impulses to be amplified for several quarters before they start dying out. Figure 1 illustrates this by plotting the estimated response of the US real exchange rate to a unit sized impulse. After the impulse, the real exchange rate keeps rising for over a year. It takes the real exchange rate ten quarters to fall below the initial size of the impulse. After this shortterm amplification, the real exchange rate mean reverts quite rapidly, falling below 1/2 the size of the impulse in 18 quarters and below 1/4 the size of impulse in fewer than 26 quarters. These hump-shaped dynamics can help explain why existing sticky price business cycle models have been unable to match the persistence of the real exchange rate. Following Chari, Kehoe, and McGrattan (2002), the literature has mostly focused on the response of the real exchange rate to monetary shocks. I present a two-country sticky price model with staggered price setting, and show that, in response to a monetary shock, the model implies an exponentially decaying response for the real exchange rate. Even with very large amounts of strategic complementarity, the rate of decay of the real exchange rate is such that the model is nowhere close to matching the empirical persistence of real exchange rates. Empirical work on vector autoregression (VAR) models suggests that only a small fraction of the variability of most macroeconomic aggregates is due to monetary shocks (Lawrence J. Christiano, Eichenbaum, and Evans 1999). I show that, in response to several different types of The Dynamic Behavior of the Real Exchange Rate in Sticky Price Models

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Cite this paper

@inproceedings{Chari2008TheDB, title={The Dynamic Behavior of the Real Exchange Rate in Sticky Price Models}, author={V. V. Chari and Patrick J. Kehoe and Ellen R. McGrattan and Robert C. Feenstra and Jan J. J. Groen and Jens Sondergaard and Martin Eichenbaum and Charles L. Evans and Kon S. Lai}, year={2008} }