Real Exchange Rate Convergence: The Roles of Price Stickiness and Monetary Policy

In many open-economy models based on Dornbusch (1976), the speed of convergence of the real exchange rate is tied to the stickiness of prices. The “purchasing power parity puzzle” concerns the empirical fact that real exchange rates appear to converge more slowly than nominal prices. In some New Keynesian models, when there is no interest-rate smoothing, the stickiness of prices does not matter at all for persistence, as Benigno (2004) showed. We show that in the presence of interest-rate smoothing, price stickiness does matter and endogenous real-exchange rate persistence is bounded above by the interest rate smoothing parameter and by the probability of a firm not changing prices under Calvo pricing. We also explain the relationship between the New Keynesian framework with Calvo pricing, and the Dornbusch framework where price stickiness is integral to real exchange rate convergence.