“The Volatility of Exchange Rates in a Search Model” by Qing Liu
The highly volatile and persistent exchange rates have always been a central puzzle in the theory of international business cycles. Moreover, there are substantial and systematic differences in the behavior of real exchange rates under fixed versus floating exchange rate regimes. These facts have posed a non-trivial challenge for international business cycle models. Traditional explanations for these features of exchange rates rely on the interaction of the nominal price rigidities and monetary shocks. In this paper we deviate substantially from the literature by developing a two-country dynamic search model to examine the behavior of exchange rates in an environment where prices are fully flexible. In contrast to traditional models, even without any nominal rigidity, our model can generate enough volatility of exchange rates observed in the data. The reason is that fluctuations in the real exchange rate arise mainly from the deviations from the law of one price, which are generated by search frictions rather than nominal price rigidities. In addition, the deviations from the law of one price depend critically on the differential between the country's valuations of the two currencies and the relative effective money holdings across countries. Because money growth shocks directly affect these two factors, they account for a larger part of the volatility in exchange rates than productivity shocks. We also compare the behavior of exchange rates under different exchange regimes. The simulated results generated by the model are consistent with the empirical findings.