Three essays in international finance

The first essay studies the role of real exchange rate stabilization in the conduct of monetary policy using a two-country DSGE model. The results suggest that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. It is also the first DSGE model to study the role of home bias in consumption in explaining the exchange rate disconnect puzzle. The model predicts the volatility of the real exchange rate relative to that of CDP increases with the extent of home bias. This relation is strongly supported by the data. The second essay is an examination of exchange rate pass-through (ERPT) into import prices in the U.K., utilizing disaggregated data. We find that the ERPT is incomplete and it varies across industries. According to Pesaran and Smith (1995), this heterogeneity can lead to an upward bias in the ERPT estimated using the aggregated import price data. We find that such an aggregation bias is significant in our data. We also find evidence that ERPT rates have declined over time in recent years. Our time series results further suggest that this decrease is highly correlated with the more stable macroeconomic environment in the U.K. The third essay tests if exchange rates are more likely to be distinguished from a random walk process at the long horizon than the short, when exchange rates behave in the manner posited by Engel and West (2005). I find that under the Engel-West explanation, long-horizon regressions generally do not have more power than the short horizon regression. Depending on the persistence of changes in the fundamental at the short horizon, two countervailing tendencies affect the relationship between the degree of autocorrelation of changes in the exchange rates and the time horizon. Both of these effects are detected in the data, thereby lending additional support to the Engel-West conjecture.