A Neoclassical Explanation of Nominal Exchange Rate Volatility

Michael John Moore · Maurice J. Roche

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Monetary Policy and Economic Impact Global Financial Crisis and Policies Economic Theory and Policy

Abstract

The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. The model is simulated using the artificial economy methodology. It successfully explains the high volatility of nominal exchange rates without recourse to sticky prices and overshooting. Nominal exchange rates are volatile because of real exchange rate variability. This, in turn, arises because the marginal rate of substitution between home and foreign goods is volatile because of the habit persistence externality.

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1999By Force of Habit: A Consumption‐Based Explanation of Aggregate Stock Market Behavior 1990Statistical Inference in Instrumental Variables Regression with I(1) Processes 1983Empirical exchange rate models of the seventies 1996Satisfaction and comparison income 1990Asset Prices under Habit Formation and Catching up with the Joneses 1997Happiness and Economic Performance 1992Understanding Consumption 1982Interest rates and currency prices in a two-country world

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