Real Exchange Rate Dynamics under Staggered Loan Contracts

In this paper, we investigate the relationship between real exchange rate dynamics and financial market imperfections. For this purpose, we first construct a New Open Economy Macroeconomics (NOEM) model that incorporates international staggered loan contracts as a simple form of the financial market imperfections. Recent empirical studies show that such staggered loan contracts are prevalent in the US, UK, and Japan and direct shocks to the bank lending interest rate (risk premium shocks) are major drivers of business cycle dynamics. Simulation results only with such a financial market friction and a risk premium shock can generate persistent, volatile, and realistic hump-shaped responses of real exchange rates, which have been thought very difficult to reproduce in standard NOEM models. This implies that these financial market developments can possibly be a major source of real exchange rate fluctuations.