9709083 Rogoff How can one reconcile the apparently very slow rate at which real exchange rate shocks damp out over time, with the extremely high volatility of real exchange rates? On the one hand, it would seem hard to explain short-term exchange rate volatility without assuming that monetary and financial market shocks are predominant. On the other hand, it is also hard to explain the apparently very long typical half life of deviations from Purchasing Power Parity - the consensus estimate is now roughly 2.5 to 5 years - unless real shocks predominate. This time frame seems far beyond anything that can be attributed to the conventional sources of nominal wage or price rigidity. This profound empirical puzzle plagues older models used in most policy research. In their previous NSF project, the investigators developed an alternative integrative approach to sticky-price dynamic open-economy models, based on dynamic maximization subject to intertemporal budget constraints, and on price-setting behavior by firms. The goal of this project is to develop variants of sticky-price intertemporal models that can explain this "purchasing power parity puzzle." The approach taken will consider a variety of possible frictions, including trade restrictions and a broad array of possible commodity arbitrage costs. One approach will involve a monetary version of a dynamic Ricardian model developed under the previous NSF grant. Another will involve incorporating pricing-to-market factors with endogenous markups. These models will be used to re-examine a provocative empirical literature arguing that real exchange rate volatility is largely benign.
