The Exchange Rate in a Dynamic-Optimizing Business Cycle Model With Nominal Rigidities: A Quantitative Investigation

Posted: 6 Jun 2001

See all articles by Robert Kollmann

Robert Kollmann

ECARES, Université Libre de Bruxelles; University of Paris XII - Department of Economics; Centre for Economic Policy Research (CEPR)

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Abstract

This paper studies a quantitative dynamic-optimizing business cycle model of a small open economy with staggered price and wage setting. The model exhibits exchange rate overshooting in response to money supply shocks. Predicted standard deviations of the nominal and, particularly of the real exchange rate are noticeably higher - and closer to the data - than in standard RBC models with flexible prices and wages. The nominal rigidities structure captures 40% to 50% of the historical standard deviations of nominal and real exchange rates of Japan, Germany and the UK vis-a-vis the U.S. during the post-BW era. It also generates improved predictions for other business cycle statistics: the predicted correlation between the nominal and the real exchange rate is markedly higher (and closer to the data) than when flexible prices and wages are assumed. In addition, the structure captures more closely the historical variability of GDP, consumption, and the nominal interest rate. The model predicts that a positive domestic money supply shock lowers the domestic interest rate, raises GDP, and triggers a depreciation of both the nominal and real exchange rate. Increases in domestic productivity and in the world interest rate are also predicted to induce a nominal and real exchange rate depreciation.

Keywords: exchange rates, nominal rigidities, business cycles

JEL Classification: F31, F32, E321

Suggested Citation

Kollmann, Robert, The Exchange Rate in a Dynamic-Optimizing Business Cycle Model With Nominal Rigidities: A Quantitative Investigation. Available at SSRN: https://ssrn.com/abstract=271951

Robert Kollmann (Contact Author)

ECARES, Université Libre de Bruxelles ( email )

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University of Paris XII - Department of Economics ( email )

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France

HOME PAGE: http://www.robertkollmann.com

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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