A Monetary Model of the Exchange Rate with Informational Frictions

53 Pages Posted: 4 May 2009

See all articles by Enrique Martínez-García

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Multiple version iconThere are 2 versions of this paper

Date Written: October 1, 2007

Abstract

Data for the U.S. and the Euro-area during the post-Bretton Woods period shows that nominal and real exchange rates are more volatile than consumption, very persistent, and highly correlated with each other. Standard models with nominal rigidities match reasonably well the volatility and persistence of the nominal exchange rate, but require an average contract duration above 4 quarters to approximate the real exchange rate counterparts. I propose a two-country model with financial intermediaries and argue that: First, sticky and asymmetric information introduces a lag in the consumption response to currently unobservable shocks, mostly foreign. Accordingly, the real exchange rate becomes more volatile to induce enough expenditure-switching across countries for all markets to clear. Second, differences in the degree of price stickiness across markets and firms weaken the correlation between the nominal exchange rate and the relative CPI price. This correlation is important to match the moments of the real exchange rate. The model suggests that asymmetric information and differences in price stickiness account better for the stylized facts without relying on an average contract duration for the U.S. larger than the current empirical estimates.

Keywords: Information Frictions, Real Exchange Rate, PPP Puzzle

JEL Classification: F31, F37, F41

Suggested Citation

Martinez-Garcia, Enrique, A Monetary Model of the Exchange Rate with Informational Frictions (October 1, 2007). Available at SSRN: https://ssrn.com/abstract=1396026 or http://dx.doi.org/10.2139/ssrn.1396026

Enrique Martinez-Garcia (Contact Author)

Federal Reserve Bank of Dallas - Research Department ( email )

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PO Box 655906
Dallas, TX 75265-5906
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