Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles

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The data show large and persistent deviations of real exchange rates from purchasing power parity. Recent work has shown that to a large extent these movements are driven by deviations from the law of one price for traded goods. In the data, real and nominal exchange rates are about 6 times as volatile as relative price levels and they both are highly persistent, with serial correlations of 0.85 and 0.83, respectively. This paper develops a sticky price model with price discriminating monopolists, which produces deviations from the law of one price for traded goods. Our benchmark model, which has prices set for one quarter at a time and a unit consumption elasticity of money demand, does not come close to reproducing these observations. A model which has producers setting prices for 6 quarters at a time and a consumption elasticity of money demand of 0.27 does much better. In it real and nominal exchange rates are about 3 times as volatile as relative price levels and exchange rates are persistent, with serial correlations of 0.65 and 0.66, respectively.

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