| The objective of this dissertation is to explore the role of habit formation in the open economy, in particular, its impact on the real exchange rate persistence and exchange rate regime. In all three chapters, closed-form solutions are available and thus we can examine habit formation's effects analytically.; In the first chapter, I use a simplified model with wage stickiness and logarithmic money demand to show, both analytically and numerically, that habit formation reduces the real exchange rate persistence, while it does increase the persistence of consumption and output as suggested in the literature. This model provides us with the intuition.; In the second chapter, I extend the model to alternative specifications. I examine two cases: the general money demand utility function and sticky prices. Both analytical and numerical analyses show that the effect of habit formation on real exchange rate persistence increases with the interest rate elasticity of money demand. The alternative nominal rigidity, the price stickiness, alters the responses of the economy to contemporaneous shocks. It thus results in different information contained in the habit stock and different implications for the persistence.; In the third chapter, I show that habit formation does not eliminate the need of the nominal exchange rate fluctuations in a local-currency pricing economy where the nominal exchange rate fails to influence the prices. Furthermore, the exchange rate flexibility is strengthened by habit formation. |
