A Neo-Classical Explanation of Nominal Exchange Rate Volatility

The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. The model is simulated using the artificial economy methodology. It successfully explains the high volatility of nominal exchange rates without recourse to sticky prices and overshooting. Nominal exchange rates are volatile because of real exchange rate variability. This, in turn, arises because the marginal rate of substitution between home and foreign goods is volatile because of the habit persistence externality