Solving Exchange Rate Puzzles with Neither Sticky Prices Nor Trade Costs
Queen's University Management School
Maurice J. Roche
National University of Ireland, Maynooth (NUI Maynooth) - Department of Economics
June 3, 2011
Journal of International Money and Finance, Vol. 29, No. 6, 2010
We present a simple framework in which both the exchange rates disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with ‘deep’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese-Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression.
Number of Pages in PDF File: 47
Keywords: Exchange Rate Puzzles, Forward Foreign Exchange, Habit Persistence
JEL Classification: F31, F41, G12Accepted Paper Series
Date posted: June 10, 2011
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