Exchange Rate Dynamics and the Welfare Effects of Monetary Policy in a Two-Country Model with Home-Product Bias

Abstract

International spillovers and exchange rate dynamics are examined in a two-country dynamic optimizing model that allows for home-product bias in consumption patterns: at given relative prices the ratio of home goods consumed to foreign goods consumed is higher in the home country. The setup nests Obstfeld and Rogoff (1995), who assume identical tastes. With home bias, results are different in three ways. When preferences are biased, the wealth transfers associated with current account imbalances induce movements in the real exchange rate and produce large short-run and small long-run deviations from consumption-based purchasing power parity. With home bias, interest rates, both real and nominal, can differ across countries; relatedly, home bias is a necessary but not sufficient condition for Dornbusch (1976) type exchange rate overshooting. Finally, in this model the welfare effects of expansionary monetary policy depend not only on world demand but also on the expenditure-switching effect of an exchange rate depreciation; monetary policy is 'beggar-thy-neighbor' if individuals have strong preferences for domestic products, but can be 'beggar-thyself' if, instead, imported goods are preferred.

Keywords: dynamic optimizing model, beggar-thy-neighbor, purchasing power parity, exchange rate overshooting

JEL Classification: E52, F31, F41