Euro-Dollar Real Exchange Rate Dynamics in an Estimated Two-Country Model : What is Important and What is Not

Author/Editor:

Pau Rabanal ; Vicente Tuesta

Publication Date:

July 1, 2006

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

We use a Bayesian approach to estimate a standard two-country New Open Economy Macroeconomics model using data for the United States and the euro area, and we perform model comparisons to study the importance of departing from the law of one price and complete markets assumptions. Our results can be summarized as follows. First, we find that the baseline model does a good job in explaining real exchange rate volatility but at the cost of overestimating volatility in output and consumption. Second, the introduction of incomplete markets allows the model to better match the volatilities of all real variables. Third, introducing sticky prices in Local Currency Pricing improves the fit of the baseline model but does not improve the fit as much as introducing incomplete markets. Finally, we show that monetary shocks have played a minor role in explaining the behavior of the real exchange rate, while both demand and technology shocks have been important.

Series:

Working Paper No. 06/177

Subject:

English

Publication Date:

July 1, 2006

ISBN/ISSN:

9781451864373/1018-5941

Stock No:

WPIEA2006177

Price:

$15.00 (Academic Rate:$15.00)

Format:

Paper

Pages:

42

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