ABSTRACT
The emergence of the real business cycle literature in the beginning of the 1980s has induced substantial progress in macroeconomic theory and technical modelling, allowing economic research to tackle new or older questions with a renewed focus. Attention has thus been drawn to the quantitative properties of the business cycles in terms of first-and second-order moments. In the field of international macroeconomics, the focus is set on matching the volatilities and the co-movements of international time series data. In a seminal paper, Backus et al. (1995) recall that the international real business cycle literature has been able to account for some salient features of international data, such as the correlation between saving and investment rates (Cardia, 1991; Baxter and Crucini, 1993), or the counter-cyclical movements of the trade balance (Mendoza, 1991; Backus et al., 1994). Yet they identify one major long lasting discrepancy. Since the beginning of
the flexible exchange rate period in 1971, nominal and real exchange rates have become extremely volatile and much more than macroeconomic fundamentals such as outputs or monetary growth factors. This puzzling behavior of relative international prices, the “price anomaly” in the Backus et al.’s (1995) terminology, has been one of the leading issues in internationalmacroeconomics. Table 2.1 taken from Backus et al. (1995) presents evidence of the high volatility of terms of trade for theG7-countries group. Table 2.2 displays larger evidence of the price anomaly: for the median of the G7 countries vis-à-vis the United States, the nominal and real exchange rates are around seven times more volatile than output. Backus et al. (1995) therefore identify the so-called “exchange rate discon-
nect puzzle” (Obstfeld and Rogoff, 2000b) that numerous papers have since been attempting to solve. Particular attention has been drawn to the role of monetary factors and nominal rigidity in line with the traditional Mundell (1963)– Fleming (1962)–Dornbusch (1976) theory. Recent research in the so-called new open-economy macroeconomics framework has thus been producing a significant renewal of old sticky-price models by introducing nominal rigidity into intertemporal general equilibrium models based on optimizing and rational agents. The seminal paper by Obstfeld and Rogoff (1995) first explores the determination of exchange rates and the international monetary transmission mechanism in a
purely analytical framework. Kollmann (2001) quantitatively assesses the story in an intertemporal, stochastic and small open economy model. Kollmann (2001) focuses on the role of imperfections on the good and labor market in the exchange rate disconnect puzzle by studying the combined role of deviations from the law of one price, staggered wage, and price setting. He derives promising results since monetary shocks generate amplified movements of nominal and real exchange rates. The present chapter shares Kollmann’s (2001) approach since we derive quanti-
tative results from a dynamic general equilibrium model, in an attempt to explain the exchange rate disconnect puzzle. We also adopt the small open economy assumption; abstracting frommovements in foreign variables allows us to identify the domestic propagation mechanisms in a very transparent way. Yet this chapter departs from Kollmann’s (2001) paper by investigating a route other than the role for nominal rigidities. We focus on the role of credit market imperfections in order
to assess the relevance of the nominal exchange rate overshooting in the exchange rate disconnect puzzle. We therefore come back to the traditional overshooting explanation given by
Dornbusch (1976) who builds “a theory that is suggestive of the observed large fluctuations in exchange rates.” In a small open economy framework Dornbusch (1976) analytically demonstrates that a home monetary injection generates an over-reaction of the nominal exchange rate beyond its steady-state level. The overshooting phenomenon is thought as a key factor for the observed exacerbated exchange rate movements.1 The objective of the chapter is to quantitatively assess the role of the overshooting dynamics in explaining the exchange rate disconnect puzzle. The framework we adopt builds on nominal price rigidity. Furthermore, as in
Dornbusch (1976), the nominal exchange rate overshooting is linked to imperfections on the market where the nominal interest rate is determined. A limited participation international business cyclemodel is then developed. Indeed, the limited participation assumption pioneered by Christiano (1991) and Fuerst (1992), aims at reproducing the persistent fall in the nominal interest rate following a monetary expansion in a closed economy setting: this assumption states that the household decides the amount of money she wants to put into the banks before the occurrence of the monetary injection. Furthermore, it is well known that a convenient way to generate a large and persistent liquidity effect consists in assuming adjustment costs on money holdings (Christiano and Eichenbaum, 1992a; King and Watson, 1996). The liquidity effect has been already analyzed in an open economy setting by
Schlagenhauf and Wrase (1995). Yet the focus of their paper is quite different from ours. The authors aim at reproducing the dynamic responses of the interest rate, the nominal exchange rate and the output given by a structural VAR model, following a monetary expansion. By using a two-country framework, Schlagenhauf and Wrase (1995) also measure the role played by the liquidity effect in the international transmission of economic fluctuations. In contrast, our chapter highlights the crucial role played by the overshooting phenomenon in explaining the exchange rate volatility. Hairault et al. (2001) recently investigated the role of credit market imperfections in a small open economy setting. They show that given the limited participation assumption, monetary shocks generate a nominal exchange rate overshooting that accounts for a substantial part of the huge observed nominal exchange rate fluctuations. Nevertheless, throughout their paper the law of one price and the purchasing parity power hold such that the real exchange rate equals one. The study of the real exchange rate behavior is consequently beyond their scope. Moreover, they adopt a flexible price framework. The present chapter extends Hairault et al.’s (2001) approach by introducing price stickiness and real exchange rate dynamics. In line with Dornbusch’s (1976) seminal paper, the theoretical framework that we retain enables us to further analyze the role of monopolistic competition and nominal rigidity together with credit market imperfections in nominal and real exchange rate fluctuations.
