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Exchange Rate Dynamics in an Intertemporal General Equilibrium Model with Nominal Rigidities, Imperfect Competition, and Investments

We develop an extension to the Obstfeld and Rogoff (1995, 1996) two-sector model with imperfect competition and nominal wage rigidities. Contrary to the Obstfeld and Rogoff (1995, 1996) analysis, we make an explicit account for the investment side of the two-sector economy. We analyze the implications for the exchange rate's reaction to an unexpected permanent rise in the money supply. The model replicates an overshooting result for certain parameter values. Moreover, we are able to isolate the effect of investments on the exchange rate. The presence of investments causes the exchange rate to overshoot less compared to the situation in Obstfeld and Rogoff (1995, 1996), in which labor is the sole factor of production.