Real Exchange Rate Volatility and Asset Market Structure

We examine the influence of financial asset market structure for the volatility of the real exchange rate. Adding distribution costs to two-country two-sector models has been shown to increase the volatility of the terms of trade and thus the real exchange rate. We argue that incomplete markets are a necessary condition for the terms of trade and real exchange rate to display realistic levels of volatility. We also illustrate that for some parameter values, how one models incomplete markets also matters for international business cycle properties of the these models.Real exchange rate volatility, financial market structure, non-traded goods, distribution costs.

Money and Monetary Policy in Stochastic General Equilibrium Models

We compare two methods of motivating money in New Keynesian DSGE Models: Money-in-the-utility function and cash-in-advance constraint, as well as two ways of modelling monetary policy: interest rate feedback rule and money growth rules. As an aid to model selection, we use a new econometric measure of the distance between model and data variance-covariance matrices. The proposed measure is useful in distinguishing between alternative general equilibrium models. We find that the models closed by an estimated interest rate feedback rule imply counter-cyclical policy and inflation rates, which is at odds with the data. This problem is not a feature of models closed by an estimated money growth rule. Drawing on our econometric analysis, we argue that the cash-in-advance model, closed by a money growth rule, comes closest to the data.Intertemporal macroeconomics, role of money, monetary policy, model selection, moment matching.

Equilibrium Exchange Rates and Supply Side Performance

This paper develops a two country, optimising, sticky price model of real exchange rate determination in the ënew open macroeconomics' tradition which allows several different forms of deviation from Purchasing Power Parity (PPP), both along the adjustment path and in the steady state. The model has a rich structure, and is designed to provide a flexible tool for policy analysis. Unlike most other papers in the literature, both of the key components of the real exchange rate -- the relative price of non-tradables, and the terms of trade -- are made endogenous, allowing a more complete analysis of the impact of structural shocks. To illustrate one possible application, the model is calibrated to match key elements of the UK and euro area economies, and used to examine the extent to which possible improvements in the UK's relative supply side performance might account for the sharp and persistent appreciation in sterling since 1996. The results are not supportive of this hypothesis. In the model, improvements in productivity, goods market and labour market competitiveness are all associated with a depreciation in both the spot and the equilibrium real sterling exchange rates. Two potential supply-side sources of an equilibrium appreciation -- a productivity improvement biased towards traded goods (Balassa-Samuelson effect), and an anticipated future productivity rise -- are considered; however each is insufficient to account for a long run equilibrium appreciation; the latter may account for an initial appreciation of the real exchange rate. We conclude by considering further mechanisms which could affect our results.

Financial intermediation and the international business cycle: The case of small countries with big banks

We examine the transmission mechanism of banking sector shocks in a two-country DSGE model. Assuming that the home country is small relative to the rest of world, we find that spillovers from foreign banking sector shocks are modest unless banks in the small country hold foreign banking assets. The correlation between home and foreign GDP rises with the exposure of the of the domestic banking sector to foreign bank assets.

Investment Frictions and the Relative Price of Investment Goods in an Open Economy Model

Is the relative price of investment goods a good proxy for investment frictions? We analyze investment frictions in an open economy, flexible price, two-country model and show that when the relative price of investment goods is endogenously determined in such a model, the relative price of investment can actually rise in response to a reduction in investment frictions. Only when the model is driven by TFP shocks do we observe a data congruent negative correlation between investment and the relative price of investment goods.Investment frictions, investment specific technological progress, total factor productivity, relative price of investment goods terms of trade.

Consumption and Real Exchange Rates with Incomplete Markets and Non-traded Goods

This paper addresses the consumption-real exchange rate anomaly. International real business cycle models based on complete financial markets predict a unitary correlation between the real exchange rate and the ratio of home to foreign consumption when subjected to supply side shocks. In the data, this correlation is usually small and often negative. This paper shows that this anomaly can be successfully addressed by models that have an incomplete financial market structure and a non-traded as well as traded goods production sector.Consumption-real exchange rate anomaly; incomplete financial markets; non-traded goods.

Exchange rate dynamics, asset market structure and the role of the trade elasticity

This paper shows that a canonical flexible price international real business cycle model with incomplete financial markets can address the exchange rate volatility puzzle, the exchange rate persistence puzzle, the consumption real exchange rate anomaly, as well as the quantity anomaly. Crucial for the success of the model is the choice of the elasticity of substitution between home and foreign produced goods. The paper shows that the range of this parameter which allows the model to address these international macroeconomics anomalies is very narrow. Furthermore, the paper highlights an anomalous relationship between real exchange rate persistence and the elasticity of substitution between home and foreign-produced goods.real exchange rate dynamics, incomplete financial markets, Backus-Smith puzzle, exchange rate persistence, trade elasticity.