Can Market Imperfections Explain the Behavior of Exchange Rates?

Document Type : Review Article

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Abstract

Some studies point out, under the assumption of the particular combination of market imperfections in both the goods and asset markets not only explain the short-run behavior of exchange rates but are also the driving force behind it. Indeed, they constitute the key element to its understanding. This paper shows that a combination of local currency pricing, heterogeneity in goods distribution, and noise trader expectation, as imperfect market, may combine to produce very high exchange rate volatility. The data in this article are related to the fixed prices in the year 2004 and run annually from 1966 to 2013 in a per capita basis. Having logarithms taken, the variables are de-traded through Hodrick-Prescott filter. The final model equations are linearized around the steady state and using Uhlig (1999) approach accidental equations are also linearized and are specified as space state pattern in Matlab software. Finally, the calibration of parameters is assessed, variables are simulated and compared with real data. The results show that the introduced model can simulate the impact of shocks on macroeconomic variables. It also shows that a money supply shock in local currency pricing, increases of the domestic consumption and thus causing a depreciation temporary of the home currency. Also, with increase in inverse of elasticity of money demand parameter, the exchange rate's response will be more to the domestic supply money shock. We find that the change in noise trader expectation can increase the nominal and real exchange rates volatility. This model shows that there is relationship between exchange rates and any macroeconomic aggregates, then "disconnect exchange rate puzzle" does not establish for economic Iran. We suggest that the government with the increase of "Tobin tax" can reduce the exchange rate volatility, of course the effect of a Tobin tax on exchange rate volatility depends crucially on the structure of the foreign exchange market and the interaction of the Tobin tax with other trading costs.

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References

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