The Exchange Rate in a Dynamic-Optimizing Business Cycle Model With Nominal Rigidities : A Quantitative Investigation

This paper studies a quantitative dynamic-optimizing business cycle model of a small open economy with staggered price and wage setting. The model exhibits exchange rate overshooting in response to money supply shocks. Predicted standard deviations of the nominal and, particularly of the real exchange rate are noticeably higher - and closer to the data - than in standard RBC models with flexible prices and wages. The nominal rigidities structure captures 40% to 50% of the historical standard deviations of nominal and real exchange rates of Japan, Germany and the UK vis-a-vis the U.S. during the post-BW era. It also generates improved predictions for other business cycle statistics: the predicted correlation between the nominal and the real exchange rate is markedly higher (and closer to the data) than when flexible prices and wages are assumed. In addition, the structure captures more closely the historical variability of GDP, consumption, and the nominal interest rate. The model predicts that a positive domestic money supply shock lowers the domestic interest rate, raises GDP, and triggers a depreciation of both the nominal and real exchange rate. Increases in domestic productivity and in the world interest rate are also predicted to induce a nominal and real exchange rate depreciation