Households' Preferences and Exchange Rate Overshooting

Abstract

This paper uses a ‘New-Open-Economy Macroeconomic’ model to study the effect of a shock to Households' preferences on exchange rate dynamics. The special features of the model are that Households' preferences exhibit a ‘catching-up with the Joneses’ effect and that international financial markets are imperfectly integrated. Results of numerical simulations of the model demonstrate that these features imply that, in an otherwise standard ‘New-Open-Economy Macroeconomic’ model, a shock to Households' preferences can give rise to an overshooting of the exchange rate.

Keywords:

• Preference shock
• financial markets
• catching-up with the Joneses
• exchange rate overshooting

Acknowledgements

The author would like to thank an anonymous referee for very helpful comments on an earlier draft version of this paper. The usual disclaimer applies.

Notes

¹In the context of the classic Dornbusch model, exchange rate overshooting has been studied, for example, by Akiba (1996), Devereux & Purvis (1990), Levin (1994), and Kempa & Nelles (1999).

²In an earlier draft version of this paper, I analyzed a model in which the condition of purchasing power parity does not hold. The draft version is available from the author upon request.

³Nakajima (2005, Section 3.6 and Appendix A.3) provides a detailed analysis of the differences between a shock to the marginal utility of consumption and a shock to the marginal disutility of labor. The key difference is that the former affects the intertemporal marginal rate of substitution, while the latter only affects the intratemporal marginal rate of substitution.