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Exchange rates, sunspots and cycles

Mauro Bambi () and Sara Eugeni ()

No 2018_05, Working Papers from Durham University Business School

Abstract: The empirical evidence on nominal exchange rate dynamics shows a long-run relationship of this variable with the fundamentals of the economy, although such relationship disappears at shorter horizons ("exchange rate disconnect" puzzle). This apparently contrasting behaviour of the nominal exchange rate can be explained in an overlapping-generations model where the two currencies are not perfect substitutes. In this framework, we show that the nominal exchange rate is pinned down by the fundamentals of the economy at the monetary steady state. However, uctuations of the nominal exchange rate around its long-run value, which are not driven by shocks to fundamentals, can emerge. Firstly, we prove the existence of endogenous (deterministic) business cycles in the nominal exchange rate. Secondly, we construct stationary sunspot equilibria where random uctuations of the nominal exchange rate arise as a result of self-ful lling beliefs.

New Economics Papers: this item is included in nep-dge, nep-mac, nep-mon and nep-opm
Date: 2018-05
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