Expectations and exchange rate dynamics: A state-dependent pricing approach

• Published in: Journal of international economics Vol. 78; no. 1; pp. 60 - 71
• Main Author: Landry, Anthony
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.06.2009; Elsevier; Elsevier Sequoia S.A
• Series: Journal of International Economics
• Subjects: Balance of trade; Business cycles; Consumption; Dynamics; Economic models; Elasticity of demand; Exchange rate dynamics; Exchange rate expectations; Expectations; Foreign exchange rates; International business cycle transmission; Output rate; Pricing; State-dependent pricing; State-dependent pricing Variable demand elasticity International business cycle transmission Exchange rate dynamics; Studies; Variable demand elasticity; F41; International business cycle transmission; Variable demand elasticity; F42; Exchange rate dynamics; State-dependent pricing
• ISSN: 0022-1996; 1873-0353
• DOI: 10.1016/j.jinteco.2009.01.010

This paper presents a two-country DSGE model with state-dependent pricing as in Dotsey et al. [Dotsey, M., King, R.G., and Wolman, A.L., 1999. State-dependent pricing and the general equilibrium dynamics of money and output. Quarterly Journal of Economics 114, 655–690] and variable demand elasticity as in Kimball [Kimball, M.S., 1995. The quantitative analytics of the basis neomonetarist model. Journal of Money, Credit, and Banking 27, 1241–1277]. Following a domestic monetary expansion, the model predicts: (i) positive hump-shaped responses of domestic output and consumption, (ii) positive spillover effects on foreign output and consumption, (iii) a high international output correlation relative to consumption correlation, (iv) a delayed increase in domestic and foreign inflation, (v) a delayed nominal exchange rate overshooting, (vi) a deterioration in the terms of trade, and (vii) a J-curve in the trade balance. The model matches the impulse responses from an identified VAR more closely than an otherwise identical model with time-dependent pricing.