Exchange rate dynamics and the welfare effects of monetary policy in a two-country model with home-product bias

Abstract

International spillovers and exchange rate dynamics are examined in a two-country dynamic optimizing model that nests Obstfeld and Rogoff (1995) and allows for home-product bias in consumption patterns. Allowing for home bias changes the results in three ways. Wealth transfers associated with net foreign asset positions induce movements in the real exchange rate and produce large short-run and small long-run deviations from consumption-based purchasing power parity. Interest rates, both real and nominal, can differ across countries; home bias is a necessary but not sufficient condition for Dornbusch (1976) type exchange rate overshooting. And the welfare effects of monetary policy depend not only on world demand but also on the expenditure-switching effect of an exchange rate depreciation; expansionary monetary policy is ‘beggar-thy-neighbor’ if individuals have strong preferences for domestic goods.