Persistent Real Exchange Rates1

Three well known facts that characterize exchange rate data are: (a) the high correlation between bilateral nominal and real exchange rates; (b) the high degree of persistence in real exchange rate movements; and (c) the high volatility of real exchange rates. This paper attempts a joint, albeit partial, rationalization of these facts in an environment with no staggered contracts and where prices are preset for only one quarter. There are two key innovations in the paper. First, we augment a standard two-country open economy model with learning-by-doing in production at the …rm level. This induces monopolistically competitive …rms to endogeneize the productivity e¤ect of their price setting behavior. Speci…cally, …rms endogenously choose not to adjust prices by the full proportion of a positive monetary shock in order to take advantage of the productivity bene…ts of higher production. Second, we introduce habits in leisure. This makes the labor supply decision dynamic and adds an additional source of propagation. We show that the calibrated model can quantitatively reproduce signi…cant fractions of the aforementioned facts. Moreover, as in the data, the model also produces a positive correlation between the terms of trade and the nominal exchange rate.