Euro-Dollar Real Exchange Rate Dynamics in an Estimated Two-Country Model: What is Important and What is Not

July 1, 2006

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Format: Chicago

Vicente Tuesta, and Pau Rabanal. Euro-Dollar Real Exchange Rate Dynamics in an Estimated Two-Country Model: What is Important and What is Not, (USA: International Monetary Fund, 2006) accessed November 21, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

We use a Bayesian approach to estimate a standard two-country New Open Economy Macroeconomics model using data for the United States and the euro area, and we perform model comparisons to study the importance of departing from the law of one price and complete markets assumptions. Our results can be summarized as follows. First, we find that the baseline model does a good job in explaining real exchange rate volatility but at the cost of overestimating volatility in output and consumption. Second, the introduction of incomplete markets allows the model to better match the volatilities of all real variables. Third, introducing sticky prices in Local Currency Pricing improves the fit of the baseline model but does not improve the fit as much as introducing incomplete markets. Finally, we show that monetary shocks have played a minor role in explaining the behavior of the real exchange rate, while both demand and technology shocks have been important.

Subject: Consumption, Exchange rates, Financial markets, Foreign exchange, Inflation, National accounts, Prices, Real exchange rates, Securities markets

Keywords: Bayesian estimation, Closed economy, Consumption, Demand shock, Exchange rate, Exchange rate-consumption anomaly, Exchange rates, Inflation, Model comparison, Real exchange rates, Securities markets, Standard deviation, Technology shock, U.S. dollar, WP

Publication Details

Pages:

42
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2006/177
Stock No:

WPIEA2006177
ISBN:

9781451864373
ISSN:

1018-5941

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