Why Is the Business Cycle Behavior of Fundamentals Alike Across Exchange Rate Regimes?

This paper develops a two-country, two-sector general equilibrium business cycle model with nominal rigidities featuring deviations from the law of one price. We show that a model with such building blocks can quantitatively account for the empirical fact that, of the statistical properties of most macroeconomic variables, only the volatility of the real and nominal exchange rates has dramatically changed after the fall of the Bretton Woods system. In particular, we replicate some explicit benchmark tests proposed in the literature (for instance, by Flood and Rose (1995)) with simulated data from our artificial economy. The presence of firms pricing-to-market and different speeds of price adjustment across sectors is important in generating the results. We show that these features dampen the upward impact of monetary policy shocks, following the introduction of a flexible exchange rate regime, on the volatility of output, consumption and especially net exports. In our model, the increase in the volatility of the real exchange rate, when the currency floats is due to an increase in the covariance of relative prices across countries. Since the variance of relative prices is not affected by the exchange rate regime, neither is that of most other macroeconomic variables.