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

44 Pages Posted: 4 May 2009

See all articles by Jens Sondergaard

Jens Sondergaard

Bank of England - Monetary Analysis

Enrique Martínez-García

Federal Reserve Bank of Dallas - Research Department

Date Written: July 1, 2008

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 akin to those in Chari, et al. (2002) and Steinsson (2008) 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 the results in Steinsson (2008) who shows how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that the CKM (2002) persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilization and investment adjustment costs (see, e.g., Christiano, et al., 2005). In summary, the PPP puzzle is still very much alive and well.

Keywords: Real Exchange Rate, PPP puzzle, Monetary Policy

JEL Classification: F31, F37, F41

Suggested Citation

Sondergaard, Jens and Martinez-Garcia, Enrique, The Real Exchange Rate in Sticky Price Models: Does Investment Matter? (July 1, 2008). Available at SSRN: https://ssrn.com/abstract=1396302 or http://dx.doi.org/10.2139/ssrn.1396302

Jens Sondergaard

Bank of England - Monetary Analysis ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Enrique Martinez-Garcia (Contact Author)

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

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