Consumption Home Bias and Exchange Rate Behavior∗

This paper studies the response of the nominal exchange rate to monetary shocks in an economy with consumption home bias (CHB) and sticky wages. The importance of accounting for the exchange rate with CHB are twofold. CHB is a consequence of the small open economy assumption when outputs are specialized and fluctuations in the relative price of traded goods generate deviations from purchasing power parity without violating the law of one price. The CHB mechanism allows monetary shocks to generate exchange rate dynamics. However, output is more sensitive to the parameter that governs expenditure switching when there is CHB. Limiting the output response to monetary shocks, whilst still generating exchange rate dynamics, places a stronger emphasis on expenditure shifting, compared to the situation in which deviations from purchasing power parity arise from failures in the law of one price. JEL Classification: E58, F32, F41.