Expectations and Exchange Rate Dynamics: A State-Dependent Pricing Approach

We introduce elements of state-dependent pricing and strategic complementarity into an otherwise standard New Open Economy Macroeconomics (NOEM) model. Relative to previous NOEM work, there are striking new implications for the dynamics of real and nominal economic activity: complementarity in the timing of price adjustment dramatically alters an open economy's response to monetary disturbances. Using a two-country Producer-Currency-Pricing environment, our framework replicates key international features following a domestic monetary expansion: (i) a high international output correlation relative to consumption correlation, (ii) a delayed overshooting of exchange rates, (iii) a J-curve dynamic in the domestic trade balance, and (iv) a delayed surge in inflation across countries. Overall, the model is consistent with many empirical aspects of international economic fluctuations, while stressing pricing behavior and exchange rate effects highlighted in the traditional work of Mundell, Fleming, and Dornbusch