Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?

This 2002 Review of Economic Studies paper by V. V. Chari, Patrick Kehoe, and Ellen McGrattan builds a quantitative two-country dynamic general-equilibrium model to test the popular story – going back to Dornbusch (1976) – that monetary shocks interacting with sticky goods prices can account for the volatility and persistence of real exchange rates, the central puzzle of international business cycles. The authors first show, using disaggregated US-Europe price data for 1973-2000, that only about 2% of the variance of the real exchange rate is attributable to movements in the relative price of nontraded to traded goods, which justifies building a model with price-discriminating monopolists and no nontraded-goods sector. Calibrating this sticky-price model with capital accumulation to US and European data, the paper finds that with high risk aversion (a curvature parameter around 5), preferences separable in leisure, and prices held fixed for about a year (matching Taylor’s 1999 survey of price-stickiness evidence), the benchmark model generates real-exchange-rate volatility close to the data (4.27 versus 4.36 times the volatility of output) and substantial, though somewhat too little, persistence (an autocorrelation of 0.62 in the model versus 0.83 in the data) – the “persistence anomaly.” The more serious failure, which the authors call the consumption-real exchange rate anomaly, is that the model’s assumption of complete international asset markets forces a tight theoretical link between the real exchange rate and the ratio of the two countries’ marginal utilities of consumption, which in turn implies a correlation between the real exchange rate and relative consumption of essentially 1 in the model; in the US-Europe data this correlation is instead mildly negative (-0.35), and across five European country-pairs it ranges from -0.48 to 0.24. The paper shows that neither of two natural remedies – replacing complete asset markets with a single noncontingent nominal bond, or adding external habit persistence to preferences – meaningfully shrinks this anomaly, and concludes that resolving it will require richer asset-market frictions rather than further tinkering with goods- or labor-market frictions.

V. v Chari | Macro Paper Warehouse

Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?