On Exchange Rate Regimes, Exchange Rate Fluctuations, and Fundamentals

Abstract

We develop a two-country, two-sector general equilibrium business cycle model with nominal rigidities featuring deviations from the law of one price. The paper shows that a model with these features can quantitatively account for the empirical fact that of the statistical properties of most macroeconomic variables, only the volatility of the real and nominal exchange rates has dramatically changed after the fall of the Bretton Woods system. In particular, we replicate some explicit non-structural tests proposed in the literature with simulated data from our artificial economy. We find that while the variability of observed fundamentals (e.g., output, money supply, and interest rates) is barely affected by the exchange rate regime, that of the exchange rate increases substantially under flexible rates.

Keywords: equilibrium business cycle, price-adjustment costs, pricing to market, exchange rate regime, exchange rate volatility, fundamentals

JEL Classification: F31