ABSTRACT
Obstfeld and Rogoff (2000b) identify six major puzzles in international macroeconomics, among which we think one of the most important is to explain why are exchange rates so volatile and so apparently disconnected from fundamentals? (Obstfeld and Rogoff, 2000b, p. 2). Indeed, the exchange rate is the key relative price in international transactions which exerts potential feedback in the whole real side of an open economy. Most existing models in international macroeconomics have difficulties accounting for the high volatility of the exchange rate. One explanation for this result lies in the fact that, in these models, the dynamics of the nominal exchange rate essentially depends on the domestic and foreign real consumption streams. It therefore inherits the excess smoothness of consumption. However, some recently developedmodels have proven to be helpful in accounting for the dynamics of the nominal exchange rate and explaining its high volatility (see Betts and Devereux, 1996; Engel, 1996; Hau, 2000; Chari et al., 2002, among others). In these models, the nominal exchange rate dynamics is fully related to that of fundamentals and most of the successes in accounting for the nominal exchange rate volatility stem from assumptions imposed on the structure of international trade (pricing to market, price stickiness). Recently, Hairault et al. (2001) proposed a small open economy version of Fuerst (1992) or Christiano (1991). Their model generates a persistent liquidity effect, and therefore – through the uncovered interest rate parity – a persistent overshooting of the nominal exchange rate following a money supply injection for high enough adjustment costs on money holdings. This mechanism is sufficient to account for the nominal exchange rate volatility. Common to all these models is the fact that they assume the existence of frictions that either affect the price-setting behavior or the revelation of information to obtain a satisfying monetary transmission mechanism to account for high enough exchange rate volatility. In this chapter, we follow another route and go back to the initial monetary
models approach, keeping the full price flexibility and complete information assumptions. We introduce intertemporal complementarities in consumption decisions in an open economy monetary model where money is held because households face a cash-in-advance constraint. More important is the fact that
households’ preferences are characterized by habit persistence, introducing time non-separability in the model. Habit persistence has proven to be a relevant assumption for representing preferences, and helpful for understanding several puzzles (see e.g. Deaton, 1992; Lettau and Uhlig, 1995; Beaudry and Guay, 1996; Boldrin et al., 2001), in particular asset pricing puzzles (see e.g. Constantidines, 1990; Campbell and Cochrane, 1999). We first show that – in our model economy – high enough habit persistence
generates real indeterminacy. It results from the interplay between habit persistence and the cash-in-advance constraint. Indeed, when individuals face the same positive belief on future inflation, higher expected inflation leads them to substitute current for future consumption, thereby increasing their habits. This translates into higher money demand for tomorrow when habit persistence is strong enough, putting upward pressure on prices. Then, inflation expectations become selffulfilling. One interesting feature of this result lies in its ability to account for the disconnection of the nominal (and the real) exchange rate from the underlying fundamentals such as interest rates, output and money supply. Indeed, when the equilibrium paths are not determinate, beliefs matter. In other words, there exists an infinite number of beliefs functions which are consistent with the rational expectation equilibrium. Nevertheless, we show that real indeterminacy is not sufficient per se to account for the dynamics of the exchange rate. When beliefs are not correlated with money injection, the model generates perfect price flexibility and money is neutral. Then the nominal exchange rate behaves exactly as in the flexible price monetary model, and does not display enough volatility. Conversely, when beliefs are correlated with money injections, the model mimics price stickiness and magnifies the volatility of the nominal exchange rate. Moreover, in this case, the propagation mechanism at play in the model is strong enough to create persistence in the dynamics of the nominal exchange rate. Furthermore, it can lead to overshooting. The model therefore highlights the importance of beliefs in the determination of the nominal exchange rate. The chapter is organized as follows. Section 6.2 presents our benchmark model
economy, insisting on the individual’s behavior. Section 6.3 characterizes the local dynamic properties of the model and discusses the conditions under which real indeterminacy occurs. After explaining the failure of the basic flexible prices cash-in-advance model, Section 6.4 discusses the role of beliefs in exchange rate dynamics. The last section offers some concluding remarks.
