Exchange Rate Dynamics, Sticky Prices and the Current Account

Abstract

RATIONAL EXPECTATIONS EXCHANGE RATE MODELS have been of two principal types flexible price models and sticky price models. The flexible price models may be further divided into those where current-account-based wealth effects are an important driving force in exchange rate dynamics and those where such effects are ignored. 1 Notably, the literature includes few sticky price models incorporating current-account-based wealth effects.2 Two reasons for the scarcity of such models are (a) the belief that current-accountbased wealth effects are empirically unimportant for exchange rates and (b) that a model endogenizing exchange rate movements, sticky price movements, and current-account-based wealth effects is relatively difficult to analyze. We note though that recent empirical work (e.g., Meese and Rogoff 1983) has called into question the empirical importance of the standard determinants of exchange rates. Consequently the criterion of empirical relevance has not yet distinguished among models of exchange rates. In connection with reason (b), note that a rational expectations, sticky price exchange rate model, where current-account-based wealth