Expectations and exchange rate dynamics: A state-dependent pricing approach

This paper presents a two-country DSGE model with state-dependent pricing as in Dotsey et al. [Dotsey, M., King, R.G., and Wolman, A.L, 1999. State-dependent pricing and the general equilibrium dynamics of money and output. Quarterly journal of Economics 114, 655-690] and variable demand elasticity as in Kimball [Kimball, M.S., 1995. The quantitative analytics of the basis neomonetarist model. journal of Money, Credit, and Banking 27, 1241-1277]. Following a domestic monetary expansion, the model predicts: (i) positive hump-shaped responses of domestic output and consumption, (ii) positive spillover effects on foreign output and consumption, (iii) a high international output correlation relative to consumption correlation, (iv) a delayed increase in domestic and foreign inflation, (v) a delayed nominal exchange rate overshooting, (vi) a deterioration in the terms of trade. and (vii) a J-curve in the trade balance. The model matches the impulse responses from an identified VAR more closely than an otherwise identical model with time-dependent pricing. (C) 2009 Elsevier B.V. All rights reserved.