Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?

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Staff Report 277

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V. V. Chari - Consultant
Patrick J. Kehoe - Monetary Advisor
Ellen R. McGrattan - Monetary Advisor

Revised July 1, 2002

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Abstract
The central puzzle in international business cycles is that fluctuations in real exchange rates are volatile and persistent. We quantity the popular story for real exchange rate fluctuations: they are generated by monetary shocks interacting with sticky goods prices. If prices are held fixed for at least one year, risk aversion is high, and preferences are separable in leisure, then real exchanage rates generated by the model are as volatile as in the data and quite persistent, but less so than in the data. The main discrepancy between the model and the data, the consumption—real exchange rate anomaly, is that the model generates a high correlation between real exchange rates and the ratio of consumption across countries, while the data show no clear pattern between these variables.

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Published In: Review of Economic Studies (Vol. 69, No. 3, August 2002, pp. 533-563)