INVESTMENT AND REAL EXCHANGE RATES IN STICKY PRICE MODELS

Abstract

This paper investigates how the inclusion of capital in the workhorse new open economy macro model affects its ability to generate volatile and persistent real exchange rates. We show that capital accumulation facilitates intertemporal consumption smoothing and significantly reduces the volatility of the real exchange rate. Nonetheless, monetary and investment-specific technology (IST) shocks still induce more real exchange rate volatility and less consumption comovement than productivity shocks (with or without capital). We find that endogenous persistence is particularly sensitive to the inertia of the monetary policy rule even with persistent exogenous shocks. However, irrespective of whether capital is present, productivity and IST shocks trigger highly persistent real exchange rates, whereas monetary shocks do not. Moreover, we point out that IST shocks tend to generate countercyclical real exchange rates—unlike productivity or monetary shocks—but have the counterfactual effect of also producing excessive investment volatility and countercyclical consumption.