Real Exchange Dynamics in Model with Habit Formation

Abstract

Much empirical evidence indicates that real exchange rates display hump-shaped dynamics. However, modern open-economy models hardly predict this behavior. In this paper, we develop a small open-economy model by extending the habit persistence parameter. This model helps us to understand real exchange rate dynamics in response to a persistent monetary policy shock under alternative monetary policy rules in an incomplete market with a risk-sharing wedge. Results indicate that incorporating a higher habit persistence parameter into the model helps replicate the hump-shaped dynamics of real exchange rates under the standard and inertial Taylor Rules. The same analyses are repeated featuring an incomplete market with portfolio adjustment cost, yielding similar results except in initial periods to previous analyses for the standard Taylor rule.