The Real Exchange Rate in Sticky Price Models: Does Investment Matter?

Abstract

This paper re-examines the ability of sticky-price models to generate volatile and persistent real exchange rates. We use a DSGE framework with pricing-to-market akin to those in Chari et al. (2002) and Steinsson (2008) to illustrate the link between real exchange rate dynamics and what the model assumes about physical capital. We show that adding capital accumulation to the model facilitates consumption smoothing and significantly impedes the model’s ability to generate volatile real exchange rates. Our analysis, therefore, caveats the results in Steinsson (2008) who shows how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that the Chari et al. (2002) persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilization and investment adjustment costs (see, e.g., Christiano et al., 2005). In summary, the PPP puzzle is still very much alive and well. JEL Classification: F31, F41, F42