The Real Exchange Rate in Sticky-Price Models: Does Investment Matter

47 Pages Posted: 27 Apr 2009

See all articles by Enrique Martínez-García

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Jens Sondergaard

Bank of England - Monetary Analysis

Date Written: April 27, 2009

Abstract

This paper re-examines the ability of sticky-price models to generate volatile and persistent real exchange rates. We use a DSGE framework with pricing to market to illustrate the link between real exchange rate dynamics and what the model assumes about physical capital. We show that adding capital accumulation to the model facilitates consumption smoothing and significantly impedes the model’s ability to generate volatile real exchange rates. Our analysis, therefore, caveats earlier work that has shown how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that so-called persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilisation and investment adjustment costs. In summary, the PPP puzzle is still very much alive and well.

Keywords: Real exchange rates, capital accumulation, Taylor rules

JEL Classification: F11, F42, F43

Suggested Citation

Martinez-Garcia, Enrique and Sondergaard, Jens, The Real Exchange Rate in Sticky-Price Models: Does Investment Matter (April 27, 2009). Bank of England Working Paper No. 368, Available at SSRN: https://ssrn.com/abstract=1395606 or http://dx.doi.org/10.2139/ssrn.1395606

Enrique Martinez-Garcia

Federal Reserve Bank of Dallas - Research Department ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States
214-922-5262 (Phone)

HOME PAGE: http://sites.google.com/view/emgeconomics

Jens Sondergaard (Contact Author)

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

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