Solving exchange rate puzzles with neither sticky prices nor trade costs |
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Authors: | Michael J Moore Maurice J Roche |
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Institution: | 1. School of Management and Economics, Queen''s University Belfast, Lanyon Building, Belfast BT7 1NN, Northern Ireland, UK;2. Ryerson University, Toronto, ON M5B 2K3, Canada |
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Abstract: | We present a simple framework in which both the exchange rates disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with ‘deep’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese–Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression. |
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Keywords: | F31 F41 G12 |
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