Pattern of Exchange Rate Distributions

Abstract

This analysis is conducted within the contect of a stochastic version of the Dornbusch (1976)
overshooting model, following the Miller and Weller (1991) extension of Krugman (1991), with shocks
to aggregate supply. Hence, three realistic features are added to the Krugman (1991) model: (i) home
and foreign products are imperfect substitutes in consumption so that purchasing power parity is
relaxed, (ii) prices and wages are sluggish, and (iii) there are intra marginal as well as infra-marginal
interventions in the foreign exchange market. The objective of this paper is thus to show that mean
reversion introduced by sluggish adjustment of prices and wages combined with a degree of intramarginal
intervention can result in a hump-shaped exchange rate distribution and thereby explain
the empirical evidence. We would like to show that the hump shape is more likely to occur when the
degree of monetary accommodation is close to what is needed to peg the nominal exchange rate (so
that the fundamental has to move far away from its mean for the exchange rate to reach its
boundaries).