Exchange Rate Volatility and Consumption Home-Bias

Abstract

This paper develops a stylised small open economy model with a closed form solution to study the behaviour of the exchange rate. Exchange rate volatility is a feature of the model when there is home-bias in consumption. In particular, when money demand is not responsive to changes in consumption the exchange rate overshoots in response to an increase in the money supply. Our results suggest that consumption home-bias is an important feature which should be incorporated into the modern approach to international finance.small open economy, consumption home-bias, exchange rate overshooting