Real rigidities and exchange rate dynamics

This dissertation explores exchange rate behavior in the presence of economic rigidities. The first chapter shows that distribution costs and costs moving labor between sectors can help explain real exchange rate volatility. The second chapter finds optimal monetary policy rules in a two-country general equilibrium environment with nontradable goods, labor immobility and a non-unitary elasticity of substitution between different types of goods.; Chapter one, "Real Rigidities and Real Exchange Rate Volatility," employs a two-country real business cycle model to demonstrate that real exchange rate movements in response to technology and preference shocks are larger if it is costly to move labor between sectors and nontradable distribution services are required for consumption of tradable goods. Model dynamics are generated by stochastic technology shocks based on Solow residuals and preference shocks based on aggregate consumption data. Without real rigidities, the real exchange rate has a lower standard deviation than output in model simulations. Introducing distribution costs and costs to moving labor between tradable and nontradable goods production lead to substantial increases in the volatility of the real exchange rate relative to other macroeconomic variables.; Chapter two, "Real Rigidities and Optimal Exchange Rate Policy," derives optimal monetary policy rules in an environment with nontradable goods, intersectoral factor immobility and a non-unitary elasticity of substitution between goods. Monetary policy is unable to replicate the flexible-price allocation in this case. When nontradable goods are introduced, the optimal monetary policy responds procyclically to a weighted average of productivity shocks in both domestic sectors. The weight depends on the share of each type of good in consumption, and, when labor is immobile, on the share of labor in each sector. When the elasticity of substitution between different types of goods is non-unitary, it is shown that optimal policy also responds to foreign productivity shocks.