Pricing-to-market, limited participation and exchange rate dynamics

Explaining the wide gap between exchanges rates fluctuations and those of their macroeconomic fundamentals since 1973, remains a challenging task for international macroeconomics. Betts and Devereux [1996. The exchange rate in a model of pricing-to-market. European Economic Review 96, 1007-1021], among others, stress the role of pricing-to-market (PTM). Hairault et al. [2004. Overshooting and the exchange rate disconnect puzzle: a reappraisal. Journal of International Money and Finance 23, 615-643] highlight an alternative explanation based on credit market frictions through the limited participation assumption (LP). The paper investigates the combined role of both types of frictions in a two-country framework. Given PTM and LP, we show that monetary shocks generate amplified exchange rate volatilities. The model hence contributes to a better understanding of the large observed exchange rate fluctuations.