Endogenous Rigidities and Real Exchange Rates

A central feature of international business cycles is that fluctuations of real and nominal exchange rates are volatile and persistent. Recent two-country dynamic general equilibrium models have explored the implications for real exchange rate fluctuations from monetary shocks in the presence of nominal rigidities. Without substantial price-stickiness, these models cannot match the persistence of real exchange rates. Our paper builds a two-country model with nominal rigidities and incomplete asset markets. Deviations from purchasing power parity arise from the need to use local labor in order to make imported goods available for consumption and production. We consider an alternative view of real marginal cost, which comprises (local and imported) produced inputs and variable utilization of the capital stock. These features reduce the elasticity of marginal cost with respect to output, thus reducing the extent of price adjustments by firms in response to a monetary shock, and generate responses of output and consumption to shifts in monetary policy that persist beyond the period of (exogenously imposed) price stickiness. Finally, we consider general demand aggregators (allowing for kinked demand functions). We explore the (quantitative) properties of our model for the volatility and persistence of nominal and real exchange rates