The Exchange Rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: A Quantitative Investigation

During the last 15 years, much effort was devoted to developing open-economy business cycle models with explicit microfoundations. With rare exceptions (discussed below), that literature considered models without money or in which money is neutral (or almost neutral), with prices and wages assumed fully flexible. A striking limitation of these models is that the predicted variability of nominal and real exchange rates is much too small compared with actual data for periods with flexible exchange rates. Recent research, however, has developed dynamic-optimizing open-economy models that do not assume fully flexible prices. This paper builds on work by Obstfeld and Rogoff (1995) and by Beaudry and Devereux (1995), who study models in which firms set their prices one period in advance. Those models, too, seem unable to generate sufficient exchange rate volatility. In the model in this paper, nominal prices and wages are set two or four periods in advance (one period represents one quarter in calendar time). In addition, a mechanism inspired by Calvo (1983) is considered that assumes that nominal prices and wages are changed after random time intervals. A semi-small open economy model with four types of exogenous shocks is assumed: shocks to the domestic money supply, to domestic labor productivity, to the world price level, and to the world interest rate. The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model exhibits exchange rate overshooting in response to money supply shocks. A positive shock to the domestic money supply is predicted to lower the domestic nominal interest rate, to raise domestic output, and to trigger a nominal and real depreciation of the country.s currency. In the model, money supply changes are the dminant source of exchange rate fluctuations.