Staff Report 223

Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates? (December 1998 Version)

Ellen R. McGrattan | Consultant
Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
V. V. Chari | Consultant

Revised December 1, 1998

The conventional wisdom is that monetary shocks interact with sticky goods prices to generate the observed volatility and persistence in real exchange rates. We investigate this conventional wisdom in a quantitative model with sticky prices. We find that with preferences as in the real business cycle literature, irrespective of the length of price stickiness, the model necessarily produces only a fraction of the volatility in exchange rates seen in the data. With preferences which are separable in leisure, the model can produce the observed volatility in exchange rates. We also show that long stickiness is necessary to generate the observed persistence. In addition, we show that making asset markets incomplete does not measurably increase either the volatility or persistence of real exchange rates.

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