Two Sector Models of the Real Exchange Rate

This thesis consists of three self contained chapters. In the first chapter, we re-assess the problem of general equilibrium models in matching the behaviour of the real exchange rate. We do so by developing a two country general equilibrium model with non-traded goods, home bias, incomplete markets and partial degrees of pass through as well as nominal rigidities both in the goods and labour markets. Our key finding is that presenting an encompassing model structure improves the performance of the model in addressing the persistence of the real exchange rate and its correlation with relative consumption, but this improvement is at the expense of failing to replicate some other characteristics of the data; where the model does a good job at explaining the failure of international risk sharing and generates substantial real exchange rate persistence, it fails to match several other observed business cycle features of the data, such as the volatility of real exchange rate and consumption.

In the second chapter of the thesis, we study the importance of the extensive margin of trade for the UK export dynamics. During the great recession, UK exports fell by around 8% with respect to their trend, more than a standard general equilibrium model would predict. In this paper, we ask whether an estimated two country DSGE model with extensive margin of trade can explain this drop and the main business cycle features of the UK economy. The extensive margin improves the overall performance of the model, but cannot improve substantially on replicating the behaviour of exports. Much of the trade collapse during the great recession can be explained by a shock to export entry costs associated with tighter financial conditions.

Understanding the trade balance dynamics has a central role in studies of emerging market business cycles. In the last chapter, we investigate the driving sources of emerging market trade balance fluctuations by developing a two country, two sector international real business cycle model with investment and consumption goods sectors. We estimate the model for Mexico and US data and find that a slowly diffusing permanent investment specific technology shock that originates in the US accounts for most of the trade balance variability in Mexico. This shock is also the key driver of business cycle fluctuations in Mexico.