Technical Note on ‘The Real Exchange Rate in Sticky Price Models: Does Investment Matter?’

Abstract

Abstract This technical note is developed in part as a mathematical companion to the paper ‘The Real Exchange Rate in Sticky Price Models: Does Investment Matter?’ (GMPI working paper no. 17). Our two-country model incorporates capital accumulation with adjustment costs, variable capital utilization and investment-specific technological shocks. Nominal rigidities and monopolistic competition distort the goods markets of each country and allow monetary policy to have real effects. We investigate two different international pricing scenarios, localcurrency pricing (where the law of one price fails) and producer-currency pricing (where the law of one price holds). This technical note contains three basic calculations. First, we derive the equilibrium conditions of the open economy model under local-currency pricing and producer-currency pricing. Second, we compute the zero-inflation, zero-trade balance (deterministic) steady state. Third, we describe the log-linearization of the equilibrium conditions around the deterministic steady state. Simultaneously, commentary is provided whenever necessary to enhance the model description and to place the assumptions embedded in our DSGE framework into context.