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Net Foreign Assets and the Exchange Rate: Redux Revived

Michele Cavallo and Fabio Ghironi ()
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Michele Cavallo: New York University

No 505, Boston College Working Papers in Economics from Boston College Department of Economics

Abstract: We revisit Obstfeld and Rogoff's (1995) results on exchange rate dynamics in a two-country, monetary model with incomplete asset markets, stationary net foreign assets, and endogenous nominal interest rate setting a la Taylor (1993). Under flexible prices, the nominal exchange rate exhibits a unit root. However, today's exchange rate also depends on the stock of real net foreign assets accumulated in the previous period. The predictive power of net assets for the exchange rate is stronger the closer assets to non-stationary and the higher the degree of substitutability between domestic and foreign goods in consumption. When prices are sticky, the exchange rate still exhibits a unit root. The current level of the exchange rate depends on the past GDP differential, along with net foreign assets. Endogenous monetary policy and asset dynamics have consequences for exchange rate overshooting under both flexible and sticky prices.

Keywords: exchange rate; monetary policy; net foreign assets; overshooting (search for similar items in EconPapers)
JEL-codes: F31 F32 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-acc and nep-ifn
Date: 2000-08-26, Revised 2002-02-01
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Published, Journal of Monetary Economics, 2002, 49, 1057-1097

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