Exchange rate dynamics in economies with portfolio rigidities

This paper analyzes the international monetary transmission mechanism in economies with portfolio rigidities. In a general equilibrium monetary model with distribution costs in trade, I analyze the reaction of the economy to technology, money supply and government spending shocks, and the ability of the model to account for some stylized facts of international business cycles. The main focus is on interest rate and exchange rate dynamics. In contrast to most limited participation models, the specification employed in this paper is able to replicate the liquidity effect and the effect of money shocks on international interest rates spreads. It also reports both a nominal and real depreciation of the domestic currency after a money injection, as observed in the data. Quantitatively, the model does relatively well in matching some business cycle moments but fails to generate the high volatility and correlations of exchange rates observed in the data.