There are several well-known facts that characterize the behavior of real exchange rates in the business cycle data: i) Real exchange rates are highly volatile relative to other macroeconomic variables such as aggregate output and consumption; ii) Changes in real exchange rates are very persistent and the real exchange rate follows approximately a random talk; iii) There are substantial and systematic differences in the behavior of real exchange rates under fixed versus floating exchange rate regimes, while fluctuations of output and consumption do not seem to change systematically with the regimes.
As an international relative price, the real exchange rate is expected to play an important role in the real allocation across countries. Thus, the real exchange rate movement should be strongly correlated with fluctuations in real variables. However, the above mentioned empirical facts suggest only a weak link between the behavior of the real exchange rate and other macroeconomic variables, which poses a non-trivial challenge for international business cycle models.
The conventional explanation for real exchange rate puzzles usually rests on the interaction of the nominal price rigidities and monetary shocks. The basic idea is simple: Monetary shocks can induce an immediate change in the nominal exchange rate; Since prices are sticky in the short run, fluctuations in the nominal exchange rate translate one for one into the real exchange rate movement. Under this explanation, the volatility of exchange rates can be much higher than their underlying fundamentals because of the sticky price and high capital mobility. The earliest version of the sticky price model goes back to the celebrated Mundell-Fleming-Dornbusch framework. With the ad hoc link between money demand and saving-investment decision, as well as the lack of an explicit theory of price setting, this framework is inadequate for understanding the real exchange rate.
The similar idea can also be embedded in the general equilibrium framework. Following Obstfeld and Rogoff’s (1995) pioneering work, a series of papers have applied the general equilibrium model with microfounded price setting to explore the features of exchange rates. Chari, Kehoe and McGrattan (2002) evaluate such models quantitatively and show that sticky price models are potentially capable of accounting for the highly volatile and persistent real exchange rates. To generate enough volatility, however, they have to assume an implausibly high risk aversion. Moreover, their model typically needs 11 quarters or longer of price stickiness to replicate the persistence in the data. Recent evidence in Bils and Klenow (2005), however, seriously calls into question the assumption of such a long-lived price stickiness.
An alternative approach to explore behavior of exchange rates is setting the model in a flexible price framework, an idea that has been implemented firstly in Stockman (1988). Later, Backus, Kehoe and Kydland (1992,1994), and Stockman and Tesar (1995) advance the so-called ”international real business cycle models” in a series of influential papers and try to use such models to match the international business data. Quantitatively, however, these models fail to explain the facts above that characterize the behavior of real exchange rates. Moreover, fluctuations of real exchange rates in such models are driven entirely by real disturbances, and persistence in real exchange rates is due to persistence in the underlying real shocks. These results are inconsistent with empirical findings which support the view that monetary shocks, rather than real shocks, account for a substantial fraction of the variability of the real exchange rate.
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Goods Market Frictions and Real Exchange Rate Puzzles
