- Abstract: This paper studies the effect of news shocks about the future technology level and performs the welfare-based policy evaluation of real exchange rate stabilization in a two-country open economy model. When prices of consumption goods across countries are sticky in the local currency, the consumption-based real exchange rate moves closely with the nominal exchange rate whose movements reflect changes in expectations of future fundamentals caused by news about the future. Consequently, the movement of the real exchange rate correctly informs the monetary policy authority of the impact of news shocks on the economy. In the sticky price economy, we show that the optimal policy rule in the presence of news shocks requires real exchange rate stabilization. When both sticky wages and prices are taken into account, the inflation-targeting policy alone amplifies the response of the economy to news shocks, creating a large welfare loss. In this case, either real exchange rate stabilization or output gap stabilization is needed to prevent the economy from overreacting to news shocks. Under the optimal policy rule, however, the role of real exchange rate stabilization in dampening the impact of news shocks is dominated by output gap stabilization because the movement of the output gap is more informative about the impact of news shocks. Nevertheless, our specification of real exchange rate stabilization implies that it is viewed as a legitimate goal of monetary policy to target news shocks in the economy with sticky wages. In addition, we show that the real exchange rate exhibits hump-shaped dynamics in response to a positive news shock and that both the real exchange rate and the terms-of-trade can either appreciate or depreciate in response to such a news shock, depending on how far into the future the shock will actually be realized.

- Abstract: We study the effect of the habit formation in consumption on the real exchange persistence under monetary policy shocks. In monetary policy models of the closed economy, the habit formation has been emphasized as an endogenous persistence mechanism so that the recent open economy literature is incorporating it into theoretical models in order to generate more persistent real exchange rate. However, there has not been a thorough evaluation of the habit formation effect in the real exchange rate context. We show that the habit formation effect depends on the assumption of the degree of price stickiness within and across countries as well as on the design of the monetary policy rule. It is shown that the habit formation does not affect the dynamics of the real exchange rate under the symmetric price adjustment setting and that it does not contribute to the persistence of the real exchange rate in a significant way for more general cases. Furthermore, it is found that the contribution of the relative price inertia inherent in the open economy to the persistence of the real exchange rate is also insignificant for plausible parameter values of the degree of price stickiness.

- Abstract: This paper investigates the nonlinear behavior of the real exchange rate under the presence of transactions costs, focusing on its behavior within the band of inaction. We decompose the real exchange rate into the nominal exchange rate and relative price by imposing the symmetry assumption, and then model their dynamics as a bivariate Threshold Vector Error Correction Model (TVECM). As expected by the evidence on nonlinearity of the real exchange rate, our empirical results provide evidence on a threshold cointegration of the nominal exchange rate and relative price. The surprising finding is that the roles of the nominal exchange rate and relative price in correcting the deviation from PPP are distinct between outside and inside the band of inaction relative to those in the linear framework. That is, it is only outside the band that the nominal exchange rate makes its significant contribution to the correction of the deviation from PPP. On the other hand, the correction by the relative price is insignificant outside the band, but there is some evidence that the relative price makes its significant adjustment to PPP inside the band. This finding implies that it is the relative price, not the nominal exchange rate, that corrects the deviation from PPP within the band, if the correction is indeed made within the band of inaction.