Endogenous real exchange rate fluctuations in an optimizing open economy model

Abstract

This paper constructs a simple intertemporal model of a small open economy inhabited by forward looking agents, in which endogenous fluctuations in the real exchange rate can arise in equilibrium, i.e. fluctuations that are not linked to movements in economic fundamentals. The key condition for the main results is the assumption that the Marshall–Lerner condition does not hold (i.e. that the country's exports and imports are inelastic to its real exchange rate). It is shown that, given that the Marshall–Lerner condition fails, there exist periodic equilibria and/or stationary sunspot equilibria in the neighborhood of the stationary state.