Countercyclical Trade Balance and Persistent Real Exchange Rates in a Neomonetarist Model

A sticky price dynamic general equilibrium business cycle model of a small open economy achieves several powerful results. Presence of physical investment and incomplete markets helps generate initial current account de cits after money shocks. The trade balance is hence countercyclical in a simulated economy, in which the business cycle is driven by monetary or persistent technological shocks. A high degree of real price rigidity for nontradable goods produces persistent deviations from purchasing power parity. Likewise, the presence of the nontradable sector can generate overshooting of the exchange rate, which depends on non-separability of labor and consumption, as opposed to the more traditional liquidity e ect based overshooting. However, the volatility of nominal and real exchange rates observed in the data can only be reproduced after the introduction of local currency pricing assumption. Lastly, the proposed model is analytically tractable, which helps obtain rm intuition before using numerical solutions.