A Model of the Exchange Rate with Informational Frictions

Data for the U.S. and the Euro-zone (12) during the post-Bretton Woods period show that nominal and real exchange rates are more volatile than consumption, very persistent, and highly correlated with each other. Open-economy models with price stickiness and local-currency pricing often require an average duration above 4 quarters to approximate those stylized facts. I argue that limited and asymmetric information introduces a lag in the consumption decisions, and as a result the real exchange rate becomes more volatile to ensure that goods markets clear at all times. Hence, informational frictions can explain the volatility of the real exchange rate without imposing price stickiness above the available estimates (e.g., Galí et al., 2001). I also find that differences in price stickiness across markets weaken the correlation between the nominal exchange rate and the CPI ratio between countries. This can increase the persistence of the real exchange rate, but often by worsening the model along other dimensions (e.g., by lowering the correlation between nominal and real exchange rates).